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INTRODUCTION TO ECONOMICS 



BY 



ALVIN S. JOHNSON, Ph.D. 

PROFESSOR OF ECONOMICS IN THE UNIVERSITY OF TEXAS 



>X*4< 



BOSTON, U.S.A. 

D. C. HEATH & CO., PUBLISHERS 

1909 



v 






n i 



Copyright, 1909, 
By D. C. Heath & Co. 



©Hi- 



C!a,A, £4 39 02 
JUL 22 T909 



PREFACE 

A cursory examination of the contents of this book will 
probably give the impression that the theoretical aspects of the 
science receive in it greater emphasis than present opinion 
among economics teachers can approve. The writer may be 
permitted to urge, in his own defense, that the method which he 
has employed was chosen not without careful consideration of 
the existing situation in the field of economics instruction. In 
the present stage of university evolution, economics is almost 
everywhere taught by men who have been trained in the science; 
a text-book writer is therefore justified in relying upon the 
teacher for the supplying of many of the concrete facts which in 
a given situation are most effective for purposes of instruction. 
An efficient teacher can base a highly practical course upon a 
text-book which is fundamentally theoretical. 

Moreover, in most corteges and universities the general course 
in economics is usually followed by special courses, and these, 
in order to attract any considerable number of students, must 
be practical. It is not too much to say that, for a majority of 
students, theoretical study begins and ends with the introductory 
course. Such a course ought, therefore, to present a reasonably 
thorough study of the general principles of the science. 

The arrangement of material in this book will perhaps require 
a few words of explanation. Every one recognizes that the fun- 
damental problem of economics is the problem of value. It is 
only when treated from the view-point of value that much of the 
material usually included in works of economics under the head 
" Production," deserves a place in the science. The student 
cannot too early familiarize himself with the true point of view 
of economics ; I have, therefore, placed the exposition of value 
in the forefront of my work. " Production " I have treated not 
independently, but chiefly in its relation to cost, and consequently 



iv PREFACE 

have placed Chapters VI-IX immediately after the chapter on 
Cost of Production. No pretense is made of treating produc- 
tion exhaustively : the writer is persuaded that this can be done 
much more satisfactorily through courses in economic history, 
economic geography, or industrial economics, than through an 
introductory work in general economics. 

In a philosophical exposition of the principles of economics, 
it would perhaps not be permissible to insert a study of labor 
organization between the theory of wages and the theory of 
interest, as has been done in this work. In a practical intro- 
duction to economics, on the other hand, this seems to the writer 
\ not only permissible, but advisable. No useful end is attained 
by relegating labor organization to a limbo of " applied eco- 
nomics " months distant from the general discussion of wages. 
When this method is adopted, the student is almost certain to 
feel that the theoretical discussion leaves no place for the most 
prominent factor in the field of labor ; and " so much the worse 
for theory." I have placed Chapters X and XI in juxtaposition, 
in order that, with the teacher's aid, the student may adjust the 
theory to the facts, and interpret the facts in the light of the 
theory. 

The greatest difficulty that the writer has encountered lies in 
the problem of capital and interest. An elementary text-book 
offers no proper place for the treatment of opposing theories. 
The writer would have found nothing more to his liking than to 
balance the arguments of the agio and the productivity schools, 
reconciling them so far as this is possible ; in his experience as 
a teacher, however, he has found that such a plan is inevitably 
destructive of the student's interest in economic science. The 
productivity theory is employed merely as more teachable than 
the agio theory, and as presenting a better approach to practical 
problems, such as stock-watering, public determination of rates 
and charges, etc. An attempt has been made, however, to famil- 
iarize the student with the method of thought of the opposing 
school in the treatment of the phenomenon of capitalization. 
Land is treated as a form of capital, chiefly because it appears 
to the writer that this method of treating the subject is destined 



PREFACE v 

to gain wide acceptance, although it is his personal conviction 
that economics has gained little and lost much through the 
abandonment of the old-fashioned distinction between land and 
capital. 

It is perhaps superfluous for the writer to mention the names 
of the economists to whom he is especially indebted. The the- 
ory of value presented is in large part derived from the works 
of von Wieser, Bohm-Bawerk, and Clark; the theories of wages 
and interest follow closely those of Professor Clark ; the treat- 
ment of rent and capitalization is influenced by the writings of 
Professors Fetter, Fisher, and Seligman. In his discussion of 
profit, the author is chiefly indebted to Clark, Landry, and 
Hawley ; in his discussion of monopoly value, he has made free 
use of the writings of Professors Marshall, Ely, and Clark. In 
the chapter on diminishing returns, the reader will recognize 
the influence of Professors Marshall and Carver. Among other 
modern economists from whom he has borrowed are Adams and 
Sumner, Jenks and Meade. 

The University of Texas, 
June 6, 1909. 



CONTENTS 



PAGE 

Chapter L The Nature of Economic Science . . i 

i. Significance of the desire for wealth, i. — 2. The desire for wealth not alto- 
gether a selfish motive, 3. — 3 Definition of wealth, 4. — 4. Human services as 
wealth, 4. — 5. Objects of desire that are not wealth, 5. — 6. Present and future 
wants in their relation to wealth, 6. — 7. Value the common characteristic of all 
forms of wealth, 6. — 8. Definition of economics, 7. — 9. Economic significance 
of the laws governing human wants, 8. — 10. The production of wealth, 8. — 
11. The distribution of wealth, 9 — 12. The practical objects of economic science, 

9. — 13. The relations of economics and politics, 10. — 14. Economics as a de- 
veloping science, 12. — 15. The exchange economy, 12. — 16 Competition, 14. 

— 17. Restrictions upon competition, 16 — 18. Economic classes, 16. — 19. Sig- 
nificance of the laws of price, 18. — 20. Summary, 19. 

Chapter II. Utility, Value, and Price . . . .21 

1. Significance of the development of wants, 21. — 2. Elasticity of wants, 22. 

— 3. Law of diminishing intensity of wants, 23. — 4. Utility, 23. — 5. Law of 
diminishing utility, 25.-6. Marginal utility, 26. — 7. Effective utility, 27. — 
8. Economic function of comparison of utilities, 28. — 9. Personal value, 29. — 

10. Socialization of personal values through imitation, 30. — 11. Socialization 
of personal values through exchange, 32. — 12. Personal exchange value, 34. — 
13. Price, 35. — 14. The determination of price in a market, 36. — 15. Demand 
and supply, 39. — 16. Qualification of the principle that marginal buyers and 
sellers control prices, 40. — 17. Summary. 

Chapter III. Normal Competitive Price . . . . 43 

1. Fluctuations in market prices, 43. — 2. Fluctuations in the prices of perishable 
commodities contrasted with fluctuations in prices of imperishable ones, 44. — 
3. Effect of extension of the market upon price fluctuations, 44. — 4. The normal 
price level, 45. — 5. Influences determining the normal price level, 47. — 6. Re- 
lation of cost of production to normal price, 48. — 7. Conflict of interest of the 
individual producers, 50. — 8. Conditions upon which adjustment of prices to the 
normal level depends, 52. — 9. Deviations from the normal price level in agri- 
cultural productions, 52. — 10. Relation of large antecedent costs to price devi- 
ations, 53. — 11. Joint products, 54. — 12. Forces determining the short-period 
normal price level, 55. — 13. The long-period normal price level, 58. — 14. Sum- 
mary, 59. 

Chapter IV. Monopoly Price 60 

1. Price control dependent upon control of supply, 60. — 2. Definition of mo- 
nopoly, 61. — 3. Monopolies established through combinations of producers, 61. 

— 4. Monopolies established through control of an essential element in produc- 
tion, 62. — 5. Intimidation as a means of monopoly control, 64. — 6. Influence — 
of competition upon partial monopolies, 65. — 7. Law of monopoly price, 66. — 

8. Influence of elasticity of demand upon monopoly price, 68. — 9. Permanent 
and temporary monopolies compared, 69. — 10. Classification of consumers for 
purposes of monopoly exploitation, 71. — 11. Monopolistic price discriminations 



viii CONTENTS 



PAGE 



in favor of foreign consumers, 73. — 12. Charging what the traffic will bear, 74. 

— 13. Limits upon monopolistic exploitation, 75. — 14. Summary, 76. 

Chapter V. The Cost of Production ... 77 

1. Prices dependent upon cost of production, 77.. — 2. Laws governing the prices 
of the materials of production, 78. — 3. Fluctuations in the price of finished prod- 
ucts are reflected in fluctuations in the prices of producers' goods, 79. — 4. The 
benefits of a rise in price of a finished product may rest permanently with the pro- 
, ducers of the crudest material entering into that product, 80. — 5. The rent of 

land suitable for one use only fluctuates with the price of its product, 81. — 6. The 
wages of labor are sometimes directly dependent upon the price of the product of 
labor, 82. — 7. Relatiun to wages of the cost of other elements in production, 84. 

— 8. Alternative uses of producer's goods as affecting their relation to the price of 
a particular product, 86. — 9. Competition of producing districts, 87. — 10. Price- 
determining and price-determined costs, 89. — 11. Summary, 90. 

Chapter VI. The Law of Diminishing Returns . . 91 

1. Increase in the output of an industry is limited by increase in cost of some 
factor or factors, 91. — 2. Increase in the business of a single establishment usu- 
ally limited by the difficulty of increasing one or more factors, 92. — 3. In most 
cases the output of an establishment can be increased only at more than propor- 
tionate increase in cost, 94. — 4. Diminishing returns in agriculture, 95. — 
5. Diminishing returns operate more severely in some forms of agriculture than 
in others, 96. — 6. Diminishing returns in urban improvements, 97. — 7. Dimin- 
ishing returns in transportation, 99. — 8. When the amount of labor increases 
while the amount of capital remains fixed, the law of diminishing returns be- 
comes operative, 100. — 9. Universal application of the law of diminishing re- 
turns, 101. — 10. The test of economy in production, 101. — n. Influences 
which counteract the tendency toward diminishing returns, 103. — 12. Sum- 
mary, 104. 

Chapter VII. The Specialization of Economic Functions . 106 

1. Economic functions undifferentiated under primitive conditions, 106. — 2. Ex- 
change as the original force making for differentiation of economic functions, 
107. — 3. Effect of production for a general market, 108. — 4. Dependence of eco- 
nomic differentiation upon the form of commercial organization, 109. — 5. Effect 
of improvements in transportation upon economic differentiation, no. — 6. Effect 
of increasing density of population, in. — 7. Relation of the form of economic 
organization to economic differentiation, 112. — 8. Business advantages arising 
from the division of labor, 113. — 9. Social advantages arising from the division 
of labor, 115. — 10. Disadvantages of the division of labor, 117. — n. Division 
of labor as a force counteracting diminishing returns, 118. — 12. Summary, 120. 

Chapter VIII. The Concentration of Industry . .121 

1. Increase in size of the business establishment, 121. — 2. Concentration de- 
pendent upon the facilities for assembling materials, 122. — 3. Concentration 
limited by the extent of the market, 123. — 4. Effect upon concentration of 
improvements in transportation, 123. — 5. Effect upon concentration of the 
growth of large fortunes, 124. — 6. The corporation, 125. — 7. The large estab- 
lishment can make the fullest use of division of labor, 126. — 8. It can avail itself 
of the most effective machinery, 127. — 9. It enjoys cheaper power, 128. — 10. It 
wastes less material, 129. — 11. It can develop valuable by-products from waste, 
129. — 12. It buys more cheaply and sells at better prices, 130. — 13. It secures 
lower rates of transportation, 131. — 14. It pays exceptionally low rates of inter- 
est, 132. — 15. The advantages of concentration vary from industry to industry, 
i3 2 - — 16. The gains from concentration are subject to a law of diminishing re- 
turns, 134. — 17. Summary, 136. 



CONTENTS ix 



PAGE 

Chapter IX. Business Combinations 137 

1. Present tendency toward combination, 137. — 2. Combination of competing 
business units, 138. — 3. Industrial integration, 138. — 4. Temporary combina- 
tions, 139. — 5. Partial combinations, 140. — 6. Consolidation, 141. — 7. Pooling, 
141. — 8. The trust, 143. — 9. The holding company, 143. — 10. Consolidation 
increases productive efficiency, 144. — 11. It encourages specialization, 145. — 

12. It reduces costs of shipment, 145. — 13. It makes possible a better adjust- 
ment of supply and demand, 146. — 14. It reduces costs of marketing, 147. — 
15. It reduces interest charges on borrowed capital, 148. — 16. Within limits, 
consolidation makes possible the control of prices, 149. — 17. Summary, 149. 

Chapter X. Competitive Wages 151 

1. Definition of labor, 151. — 2. Definition of wages, 152. — 3. The importance 
of the problem of contract wages, 153. — 4. Wages vary according to the con- 
ditions under which labor is employed, 154. — 5. Equal wages for equal tasks, 
154. — 6. Wages cannot exceed the marginal productivity of labor, 156. — 
7. Under competition wages cannot long be less than the marginal product of 
labor, 157.— 8. Effect upon wages of increase in the efficiency of labor, 159. — 
9. Effect upon wages of increase in the number of laborers, 159. — 10. Effect 
upon wages of improvements in production, 160. — ■ n. A reduction in the rate 
of interest raises wages, 161.— 12. Non-competing classes of laborers, 162. — 

13. Effect upon wages of the apportionment of new laborers, 163. — 14. Per- 
manent influences affecting the distribution of labor, 164. — 15. The standard of 
living, 169. — 16. Summary, 172. 

Chapter XI. Wages as affected by Labor Organization 173 

1. Inferiority of the laborer in bargaining power, 173. — 2. Labor organization 
as a means of increasing the bargaining power of labor, 173. — 3. The trade 
union, 174. — 4. The closed shop, 175. — 5. Apprenticeship regulations, 176. — 
6. The importance of trade-union funds, 178. — 7. Alliances between trade 
unions, 178. — 8. National labor organizations, 179. — 9. The American Feder- 
ation of Labor, 181. — 10. The strike, 181. — n. The boycott, 182. — 12. The re- 
lation of trade unionism to the strike and boycott, 183. — 13. Collective bargaining, 
184. — 14. Voluntary arbitration, 185. — - 15. Public opinion and arbitration, 186. 
— 16. Compulsory arbitration, 187. — 17. Labor organization and the competi- 
tive law of wages, 188. — 18. Restriction of output as a cause of reduced wages, 
189. — 19. Summary, 190. 

Chapter XII. The Productivity of Capital . . .192 

1. Capital goods, 192. — 2. Capitala fund of productive wealth, 193. — 3. Theper- 
manence of capital, 194. — 4. Acquisitive and productive capital, 196. — 5. Arti- 
ficial and natural capital, 197. — 6. Saving, 197. — 7. The growth of natural 
capital, 199. — 8. The productivity of capital goods, 199. — 9. The productivity 
of capital, 200. — 10. The productivity of capital determined at the margin, 201. 
— n. Effects of an increase in capital, 204. — 12. Law of diminishing productiv- 
ity of capital, 205. — 13. Influences counteracting the law of diminishing pro- 
ductivity of capital, 207. — 14. Effect upon the productivity of natural capital of 
increase in artificial capital, 207. — 15. Equalization of returns to capital through 
revaluation, 208. — 16. Equalization of returns to capital through mobility of 
capital, 209. — 17. Barrier preventing the free flow of capital from industry to 
industry, 211. — 18. Summary, 213. 

Chapter XIII. Rent, Interest, and Capitalization . .215 

1. Popular meaning of the term rent, 215. — 2. The traditional scientific use of the 
term, 215. — 3. Rent as the product of a capital good, 216. — 4. Rent restricted 
to the product of durable capital goods, 216. — 5. Rent and interest, 217. — 



CONTENTS 



PAGE 



6. Rent as a residue, 218. — 7. The determination of the rent of one of several 
goods entering into a permanent combination, 221. — 8. The rent of a reproduc- 
ible capital good tends to equal interest on the cost of replacing the good, 221. — 

9. The relation of ground rent to wages and interest on artificial capital, 222. — 

10. The relation of the prices of the products of land to the rent of the land, 225. 
— 11. The tendency of ground rents to rise, 227. — 12. Capitalization, 228. — 

13. Method of ascertaining the amount of capital in reproducible and irreproduc- 
ible goods, 228. — 14. Effect of an increase of artificial capital upon the volume 
of land, 231. — 15. Summary, 231. 

Chapter XIV. Enterprise and Business Profits . . 233 

1. Business opportunities, 233. — 2. Enterprise, 234. — 3. The relation between 
economic changes and the opportunities for enterprise, 236. — 4. Enterprise a risk, 
236. — 5. Enterprise and imperfect competition, 237. — 6. Definition of profit, 
238. — 7. The nature of profits, 238. — 8. Profits due to abnormally low wages 
and interest, 240. — 9. Profits due to the transfer of labor and capital from one 
environment to another, 241. — 10. Profits due to the transfer of an industry from 
one environment to another, 243. — 11. Conditions under which all enterprises 
gain profits, 244. — 12. Profit a temporary income, 245. — 13. Monopoly profits 
may have permanence, 246. — 14. Monopoly may be capitalized, 248. — 15. Func- 
tion of competitive profit, 249. — 16. The evil effect of monopoly profits, 250. — 
17. Summary, 251. 

Chapter XV. Money 253 

1. Definition of money, 253.-2. Origin of money, 254. — 3. Functions of 
money, 255. — 4. Qualities that money should have, 256. — 5. Lack of uni- 
formity in money without government control, 257. — 6. Functions of govern- 
ment relative to the monetary system, 258. — 7. Methods of maintaining parity, 
260. — 8. Gresham's law, 261. — 9. The value of money, 262. — 10. Measure- 
ment of fluctuations in the value of money, 263. — 11. Effects of changes in the 
quantity of money, 263. — 12. Effect on prices of the issue of paper money, 266. 
— 13. Effect on prices of the introduction of substitutes for money, 266. — 

14. Effect of changes in the volume of business upon the value of money, 267. — 

15. The effects of an increase in the supply of money not capable of exact 
measurement, 268. — 16. Importance of changes in the price level, 269. — 
17. Government regulation of the money supply, 271. — 18. The silver move- 
ment, 272. — 19. Probable effects of free silver, 273. — 20. International bimet- 
allism, 273. — 21. Decline of the silver party, 274. — 22. Paper money, 274. 
— 23. Forces regulating the value of gold, 277. — 24. Summary, 277. 

Chapter XVI. Financial Institutions: The Bank . . 280 

1. Finance as the placing of capital, 280. — 2. Forms of capital placement, 281. — 
3. The loan, 281. — 4. Disguised loans, 282. — 5 Credit, 283. — 6. Credit instru- 
ments, 283. — 7. Demand for a supply of loanable capital, 284. — 8. Functions 
of the bank, 286. — 9. Bank loans regarded as the purchase of credit instruments, 
289. — 10. Kinds of investments suitable for banking purposes, 290. — 11. De T 
posits arising out of loans, 291. — 12 The clearing system, 293. — 13. Bank 
reserves, 294. — 14. Risks incurred by bank depositors, 296. — 15. Bank notes, 
297. — 16. Restrictions upon note issue, 298. — 17. Notes and deposits as cur- 
rency, 300. — 18. Summary, 300. 

Chapter XVII. Other Financial Institutions . . 303 

1. Permanent investment of free capital, 303. — 2. Demand for long-term invest- 
ment funds, 303—3. Supply of long-term funds, 305. — 4. Instruments of 
long-term investments, 306—5. Variation in security of investments, 307.— 
6. Variation in transferability of investments, 308. — The productiveness of 



CONTENTS xi 



PAGE 

an investment, 308. — 8. Effect of risk upon productiveness, 309. — 9. Effect of 
difficulty of transfer upon productiveness, 310. — 10. Machinery for placing cap- 
ital, 310 . — 11. Stock Exchange, 312. — 12. Speculation, 312. — 13. Economic 
function of speculation, 313. — 14. Underwriting syndicates, 315. — 15. The in- 
vestment company, 316. — 16. The savings bank, 317. — 17. The building and 
loan association, 319. — 18. The life insurance company, 320. — 19. Complexity 
of the financial mechanism, 321. — 20. Summary, 322. 

Chapter XVIII. International Trade and Foreign Ex- 
change 324 

I. The basis of permanent trade, 324. — 2. Local and interregional trade, 326. — 
3. Interregional trade based upon absolute differences in productive powers, 
327. — 4. Interregional trade based upon relative differences, 327. — 5. Interna- 
national trade may originate in differences in character of population, 328. — 

6. It may originate in differences in relative supply of natural agents, 329. — 

7. It may originate in differences in the supply of capital, 330. — 8. It may 
originate in differences in traditions of workmanship, 331. — 9. The foreign 
trade of a modern nation is based upon a variety of conditions, 332. — 10. Rela- 
tive, not absolute advantages in production give rise to exportation, 333. — 

II. Relative advantages are reflected in money cost of production, 334. — 

12. Application of the principles of distribution to foreign trade, 335. — 

13. Trade between countries is essentially barter, 337. — 14. Bills of exchange, 
338. — 15. Fluctuations in the price of bills of exchange, 339. — 16. Conditions 
determining the price of bills, 340. — 17. Exchange on all foreign points tends to 
fluctuate uniformly, 342.— 18. Effect of increase in exports or in imports upon 
the price of foreign bills, 344. — 19. Effect upon exports and imports of fluctua- 
tions in foreign bills, 344. — 20. Exportation and importation of gold, 345. — 
21. Summary, 347. 

Chapter XIX. The Regulation of Foreign Trade . . 348 

1. Foreign trade regulated by taxation, 348 — 2. Revenue and protective duties, 
349. — 3. Popularity of revenue duties on imports, 350. — 4. Import duties borne 
by the consumer, 352. — 5. Protective duties as a means of maintaining the 
money supply, 352. — 6. Fallacy of discouraging importation from countries 
which do not take commodities in exchange, 353. — 7. Fallacy of patronizing 
home industry, 354. — 8. General protection an impossibility, 356. — 9. Wages 
not dependent upon protection, 357. — 10. Protection may reduce real wages, 359. 
— 11. Some of the effects of protection are seen, while others are unseen, 361. — 
12. Protection may increase the product of industry if the government has better 
business ability than the body of private enterprisers, 362. — 13. Protection may 
aid productive industries in overcoming the hardships of infancy, 363. — 14. Pro- 
tection should be withdrawn from an established industry, 364. — 15. Difficulty 
of determining when protection becomes unnecessary, 365. — 16. Inadvisability 
of establishing industries requiring permanent protection, 365. — 17. Protection 
as a means of preserving natural resources, 367. — 18. Protection as a means of 
preserving the vigor of the working population, 368. — 19. Protection as a means 
of making a country independent in time of war, 369. — 20. Inadvisability of 
seeking complete self-sufficiency, 370. — 21. Retaliatory duties, 371. — 22. Sum- 
mary, 373. 

Chapter XX. The Relations of Government to the 

Economic Organization .... . . 374 

1. Interdependence of law and economics, 374. — 2. Free enterprise, 375. — 
3. Criticism of the system of free enterprise, 376. — 4. The question of produc- 
tive efficiency, 377. — 5. The question of distribution, 377. — 6. Distribution as 
between recipients of profits, 378. — 7. As between laborers, 379. — 8. No stand- 



xii CONTENTS 



ard of justice ascertainable in distribution between different classes, 379. — 9. In- 
equalities in bargaining powers vitiate the results of free contract, 380. — 10. Free 
enterprise approaches justice only when competition rules, 380. — it. Need for 
governmental interference, 381. — 12. Regulation of qualities of goods and ser- 
vices, 383. — 13. Regulation of the prices of goods or services, 384. — 14. Regu- 
lation of the conditions of employment, 386. — 15. Regulation of wages, 388. — 
16. Regulation of relations of landlord and tenant, creditor and borrower, direc- 
tor and stockholder, 38Q. — 17. Governmental regulation not incompatible with 
free enterprise, 391. — 18. Government ownership for revenue, 392. — 19. Gov- 
ernment ownership for purposes of regulation, 393. — 20. Industries producing 
inappropriable utilities, 395. — 21. Conditions under which public replaces pri- 
vate enterprise, 398. — 22. Summary, 399. 



INTRODUCTION TO ECONOMICS 

CHAPTER I 

THE NATURE OF ECONOMIC SCIENCE 

1. The desire for wealth has in all ages been one of the 
principal motives of Jiuman action. 

From the earliest time of which we have record a great 
part of the activity of man has been occupied with the 
production or acquisition of wealth — material objects and 
personal services upon the control of which human welfare 
depends, or seems to depend. In the long ages of sav- 
agery and barbarism primitive man was engaged in a cease- 
less struggle with nature for the bare means of existence 
— food, clothing, and shelter. Limited as were the sup- 
plies afforded by nature, a savage tribe never long en- 
joyed them in peace; other tribes coveted the hunting 
grounds, or the bays where shellfish abounded; the rich 
pastures, or the groves of fruit-bearing trees. Hence 
the difficulty of obtaining from nature the means of sub- 
sistence was aggravated by constant warfare between tribe 
and tribe. A struggle for mere existence against nature 
and against hostile tribes — such was the life of primitive 
man. 

From century to century man learned to equip himself 
better for the struggle for existence. Tools, at first rudely 
wrought from stone, later from the metals, greatly in- 
creased his productive power. A yet greater step in ad- 
vance was made when animals were domesticated, and a 
certain and steady food supply took the place of the pre- 
carious products of the chase. The cultivation of roots 

i 



2 INTRODUCTION TO ECONOMICS 

and grains that had in their wild state yielded scanty re- 
turns to the gatherer marked another stage of progress. 
Methods were crude, and the tasks of pastoral and agri- 
cultural life exceedingly laborious — a condition which 
gave rise to the enslaving of captives taken in war. With 
the increase in productive power, limited classes were 
freed from the economic struggle and were enabled to 
devote their energy to ends less intimately connected with 
the pursuit of wealth — politics, literature, art, religious 
organization. Every advance in the productive power of 
society has increased the relative number of those who 
are free to engage in activities that add nothing to the 
social wealth. 

It remains true, nevertheless, that the great majority of 
men are mainly occupied with the pursuit of wealth. This 
is in large measure due to the fact that a man's desire for 
material welfare is capable of indefinite expansion. Merely 
to possess food sufficient to satisfy hunger does not content 
him ; the food must be pleasing to the palate as well as 
nutritious. Warm clothing is an excellent thing; but civil- 
ized man demands that his clothes be of good appearance 
as well as comfortable. A sod house on the prairie is con- 
structed with no great amount of labor and almost no 
expense ; in such a house one may defy the worst storms 
of winter and the hottest winds of summer. Yet the mod- 
ern dweller on the plains would scorn to live in such an 
abode ; his home must present an appearance of comfort 
and prosperity. To stand well with one's fellows is to 
most men hardly less important than life itself, and in all 
human history a chief factor in winning and retaining the 
esteem of others has been the possession of proper attire 
and other personal appointments. There is a standard of 
wealth consumption which each little group of associates 
in society is under some sort of compulsion to attain. If 
my neighbors and friends all have fine houses, I cannot 



THE NATURE OF ECONOMIC SCIENCE 3 

enter my humble dwelling without a sense of inferiority. 
If they are well dressed, I desire to be equally well dressed. 
If they are wise or learned or cultured, I naturally strive to 
emulate them in this respect also. But-one cannot be well 
clad or well housed, one cannot without great difficulty be 
wise or learned or cultured, unless one can command a fair 
amount of wealth, an amount far in excess of the bare needs 
of existence. Under modern conditions wealth has become 
a means — though, of course, not the only means — to most 
of the things which one can desire. And as it is not in the 
nature of man to be content for any long time with what he 
possesses and what he has attained, it is inevitable that his 
desire for wealth, which is so potent a means for further 
attainment, should continue unabated. 

2. A man desires wealth not only for the satisfaction 
that it may give himself, but also for the satisfaction it 
may give those whose interests he regards as his own. 

Nothing is more common than to stigmatize the desire 
for wealth as a narrowly selfish motive. As a fact there 
are comparatively few men who desire wealth merely for 
the sake of the personal gratification that they expect to 
derive from it. It is not too much to say that the normal 
man is more desirous that his wife and children should 
enjoy the comforts of wealth than that he should enjoy 
them himself. There are some persons whose desire for 
wealth is animated chiefly by the needs of a group of 
persons in no way connected with them by ties of kinship. 
The founders of free hospitals, orphan asylums, sailors' 
homes, and the like are types of this class. Some persons 
have sympathies so broad as to include all the citizens 
of a country within the group for whom they desire the 
benefits of wealth. The greatness of Pericles consisted 
partly in his ardor for advancing the material prosperity of 
the Athenians, even through the exploitation of allied 
states. 



4 INTRODUCTION TO ECONOMICS 

We may therefore say that the desire for wealth ani- 
mates the purest and most unselfish of men as well as the 
most sordid. The desire for wealth is a desire for means 
to ends, and these may be good or evil. The philanthropist 
who wishes to found a home for invalid children must have 
wealth, just as the voluptuary who desires a palace of all 
delights to please his jaded senses. The economic motive 
animates both ; very likely the philanthropist desires 
wealth the more ardently. What differentiates the two is 
the end which the wealth is meant to subserve. To assert, 
then, that all men are in great measure actuated by economic 
motives is not to assert that all men are selfish or sordid. 
It is merely to assert that wealth has been placed between 
man and the satisfaction of most of his desires ; that as he 
seeks to attain any end whatsoever, he will seek to possess 
the means to that end. 

3. Wealth consists of all material objects and human 
services which can be made subject to mans control and 
upon which man depends for the satisfaction of his wants. 

The apples in one's orchard are wealth ; they are subject 
to one's control, and their consumption yields satisfaction. 
Even if their owner does not care for apples, they are 
wealth to him if through exchanging them he can gain 
control of other objects capable of satisfying his wants. 
The trees which bear the apples and the land upon which 
they grow are also wealth, as they are necessary means to 
the production of the fruit. Wealth, then, includes those 
things that satisfy desires immediately, or consumers' goods,. 
and those things that serve as means for producing objects 
of immediate desire, ox producers' 1 goods. Both classes to- 
gether constitute economic goods. 

4. Human services may satisfy wants directly or in- 
directly. 

The services of an actor, a musician, or an orator result 
in the immediate satisfaction of desire. The services of a 



THE NATURE OF ECONOMIC SCIENCE 5 

mason, a plasterer, or a carpenter embody themselves in 
material form. Bricks in the form of a house have a 
utility superior to that of an equal number of bricks in a 
material yard, and the measure of this superiority is the 
measure of the services of the bricklayer. 

In summing up the annual production of wealth of a 
given country, it is necessary to take account of the ser- 
vices yielding immediate satisfaction. It is not necessary 
to take account of the services resulting in the indirect 
satisfaction of desires, as these are embodied in material 
objects, which are always taken into account in estimating 
the production of wealth. 

5. Nothing can be wealth unless the total supply is so 
narrowly limited that every part of it is necessary to satisfy 
existing wants. 

The sun in spring satisfies an intense want of mine ; so 
also do showers in the dry season. But these things are 
not part of my wealth, as they are not subject to my 
control. The air I breathe satisfies my most intense want, 
but it is not wealth. Though my life depends upon a con- 
stant supply of air, it cannot be said to depend upon any 
specific part of the existing volume. If my fire consumes 
part of the oxygen in the air of my room, thus, for all 
practical purposes, destroying the air, a fresh supply flows 
in through the open window, without effort or thought on 
my part. Since no particular part of the supply of air is 
of any special importance, air cannot be wealth. 

In a newly settled country standing timber is often so 
plentiful that all possible need for it for firewood or for 
lumber falls far short of absorbing the entire supply. In 
such circumstances standing timber can have no place in 
the list of objects composing wealth. If one man's wood 
were swept by fire he would find no difficulty in securing 
timber gratis from other men. When land itself is so 
plentiful, relatively to the need for it, that not all the best 



6 INTRODUCTION TO ECONOMICS 

land is occupied, no man's welfare is dependent upon his 
control over a particular tract of land. If in the early 
part of the nineteenth century a squatter in the Ohio 
Valley had been dispossessed from the land which he 
occupied, he would have lost nothing but the improve- 
ments which he had fixed in the soil. The land, there- 
fore, was no part of his wealth. 

6. The wants that endow a class of objects with the 
quality of wealth may originate in present needs or in 
anticipated future needs. 

The coal fields of Utah are capable of producing a far 
greater supply of coal than the persons who now have 
access to those fields can possibly use. If man lived in 
the present alone, these coal fields could not be classed 
as wealth. But it is generally recognized that at some 
future time the mines in that region will be unable to 
supply all need for fuel. The anticipated future need 
affects the present calculations of men and leads them 
to class the coal fields among the objects at present con- 
stituting wealth. In like manner, land fit only for building 
sites in the vicinity of a growing city acquires a place 
among objects of wealth even when it is far in excess of 
the present needs of the population. Indeed, far the 
greater part of the wealth of a modern country is designed 
to satisfy future, not present, needs ; and the greater the 
wealth and the business capacity of a people, the greater 
will be the provision for future needs. 

7. Value is the one property that all forms of wealth have 
in common. 

The various objects that compose the wealth of an in- 
dividual or of a society form a heterogeneous mass, and, 
from a physical point of view, have no characteristics in 
common. What could be more dissimilar, physically con- 
sidered, than a steam engine and the music of an orches- 
tra ? From the point of view of human need, however, 



THE NATURE OF ECONOMIC SCIENCE 7 

they have something in common. Both may be desired ; 
and the desire for one may be measured in terms of that 
for the other. Both are valuable ; the one may be twice 
as valuable as the other. In this case we should say that 
the one represents twice as much wealth as the other. 
Value is the universal characteristic of wealth, and it is 
in terms of value alone that wealth can be measured. 

8. Economics is the science which deals with wealth in 
its most general aspect; namely \ its value aspect. 

Gold and silver are forms of wealth. They have well 
marked physical characteristics which distinguish each from 
the other and from all other physical objects. These 
characteristics are not, however, of direct concern to eco- 
nomics. Each possesses value, and this fact is of immediate 
importance to economic science. That an ounce of gold 
is worth more than thirty-five ounces of silver is an eco- 
nomic fact ; that silver is harder or whiter than gold is not 
an economic fact. True, differences in physical character- 
istics may account in part for differences in value; but 
that physical differences are not a sufficient explanation 
of differences in value is clearly shown by the fact that 
the former remain constant, while the latter change from 
day to day. 

There is a body of principles determining the proper 
use of each form of iron and steel. One kind of steel 
may properly be used for rails, another kind may not be. 
These laws and principles, however, are not a part of 
economics, because they are not sufficiently general. 
They fall properly under the science of metallurgy. The 
science of agriculture treats of the various economic 
plants, of the physical and chemical properties of agri- 
cultural products, of their distribution over the earth and 
of the uses to which they are adapted. This science, 
however, is no part of economics, since its laws are opera- 
tive only in a special field. An inquiry into the value of 



8 INTRODUCTION TO ECONOMICS 

iron or of corn, or into the value of the indirect goods that 
are employed or used up in the production of iron or corn, 
would properly fall within the domain of economic science. 

9. Economic science derives many of its premises from 
the laws governing human wants or desires. 

Economics is the science of wealth. Nothing can be 
wealth — that is, possess value — unless it is desired, and 
the degree of desire determines in large measure the 
degree of value. There are some things that are desired 
intensely if their supply is narrowly limited, while, if their 
supply becomes very great, they are scarcely desired at 
all. Diamonds fall in this class. Other things are not 
desired very intensely even if their supply is small ; if the 
supply is vastly increased, the desire for each part of the 
supply is not greatly reduced. Many kinds of food fall 
in this class. With the progress in wealth some things 
come to be desired more intensely, other things less in- 
tensely. Objects for future use are desired less intensely 
under one set of conditions than under another. We 
see, then, that in order to explain values it is necessary to 
take account of the laws governing human wants. These 
laws are usually grouped by economists under the head of 
the " Consumption of Wealth." 

10. Economics deals with the general laws governing the 
production of wealth. 

There are laws governing the production of wealth that 
are operative in all branches of industry, or at any rate, in 
a wide range of industries. Everywhere we find a tendency 
toward more narrow specialization of function on the part 
of the laborer ; everywhere we see a tendency to substitute 
machine production for hand production. In a large num- 
ber of industries we find the business establishment increas- 
ing in average size from decade to decade. In a large 
number of industries an increase in the amount of product 
may be had only at a disproportionate increase in labor 



THE NATURE OF ECONOMIC SCIENCE 9 

and expense. These laws and related ones are grouped by 
economists under the head of the " Production of Wealth." 

11. Economics deals with the distribution of wealth 
among the different classes of which society is composed. 

The most prominent characteristic of modern industrial 
life is that commodities are produced, as a rule, through 
the joint efforts of many individuals. There was a time 
when the blacksmith smelted his own iron and controlled 
each stage in the process until the finished nail or horseshoe 
was in the consumer's hands. To-day, probably a thousand 
men have cooperated in the production of even so simple 
an article as a horseshoe. The value thus produced must 
be distributed in some way among the various producers. 
Those who have contributed labor receive wages ; those 
who have contributed capital receive interest. What de- 
termines how large a share of the total value shall go to 
the laborers, how large a share to the owners of capital ? 
There are general principles governing this distribution, 
and these form perhaps the most interesting and important 
part of economics. These laws are grouped by economists 
under the head, "The Distribution of Wealth." 

12. Economics is a practical science ; its chief function is 
to throw light upon questions of political policy. 

Economics as a distinct science may be said to have 
taken its rise in studies concerning taxation and public 
finance. In early modern times the expenditures of govern- 
ment in most European states were steadily increasing. 
The various princes vied with one another in the splendor 
of their palaces and in the number and brilliancy of their 
personal following ; the cost of maintaining the tranquillity 
of the nation at home, and its dignity and influence in for- 
eign lands, became heavier from decade to decade. More 
than all, methods of warfare by land and by sea were 
changing, and military success was coming to depend quite 
as much upon the size of the war chest as upon the valor 



io INTRODUCTION TO ECONOMICS 

of the soldiers. These new expenditures could be met only 
through taxation ; accordingly, it became a very practical 
matter for the statesman to devise means for increasing the 
prosperity of a nation in order to increase its capacity for 
paying taxes. As the precious metals seemed to be the 
most convenient and the most stable form of wealth, it 
was the aim of the statesman to provide these in abundance. 
European countries, having no important mines of silver 
and gold, could secure these metals only through foreign 
trade. Hence the kernel of early modern economic policy 
was the regulation of foreign trade, with a view to bringing 
into a country large supplies of treasure. These regula- 
tions formed a system which in the end became burdensome 
in the extreme ; their futility and injuriousness were ex- 
posed in the latter half of the eighteenth century by the 
Economistes in France and by Adam Smith in Great Britain, 
whose writings first placed economics on a scientific basis. 

Through the nineteenth century economic discussion has 
progressed from one practical problem to another — ■ money 
and banking, trade unionism, socialism, monopoly, etc. 
The chief function of the science is still, as. in its earliest 
period, to ascertain what economic policy of government 
will be most conducive to the general welfare. Although 
it is known as the "science of wealth/' it is not the func- 
tion of economics to instruct individuals how they may best 
acquire wealth. Its principal aim has been attained when 
it has thrown all possible light upon the economic prob- 
lems which a state, and its members as citizens of a state, 
may need to solve. 

13. Most of the political problems of the present time are 
economic in their nature. 

The importance of economics to the citizen of a modern 
state is clearly seen when we enumerate the issues that 
have held a prominent place in national politics. In the 
presidential campaign of 1908, revision of the tariff, regu- 



THE NATURE OF ECONOMIC SCIENCE n 

lation of business corporations, and reform of our banking 
system, were among the most important subjects of dis- 
cussion. All these questions are almost purely economic 
in their nature. The money question, the labor question, 
the railway problem, speculation and crises, are further 
economic problems upon which every citizen ought to be 
able to form an intelligent opinion. 

Most of us have at some time speculated upon the apparent 
injustice in the distribution of rewards and services under 
the existing economic system. Is it right that the unskilled 
laborers, whose hours are long, and whose toil is hard and 
uninteresting, should receive only the smallest pittance, while 
the successful lawyer or architect receives a princely income 
for work that may afford him the greatest pleasure ? Many 
able thinkers have utterly condemned the existing economic 
system because of this inequality of rewards ; they would 
substitute a plan of sharing which would give to each accord- 
ing to the time spent or according to the degree of exertion. 
Certainly, this would increase the welfare of many who 
now have far too little; it might not seriously injure those 
who have more than is necessary for comfortable existence. 
Yet could such a change be made without setting in motion 
influences which in the end would leave the rich poor and 
the poor more wretched than they now are ? The question 
is one that cannot be answered without a thorough study 
of the laws governing the production and distribution of 
wealth under modern conditions. 

It is now clear why economic study, though of recent 
origin, is prosecuted with more zeal than almost any other 
department of science. It is concerned with one of the most 
vital of all subjects — the general welfare. Without economic 
science the existing constitution of society cannot be under- 
stood ; unless based upon an adequate understanding of 
economic laws, attempts at practical reform of recognized 
evils are likely to do more harm than good. 



12 INTRODUCTION TO ECONOMICS 

14. Economics must ever remain a developing body of 
thought, since economic life, which it is designed to explain, 
is constantly changing. 

Had a Greek philosopher attempted a systematic treatise 
on economics, we should find in it comparatively little that 
would assist us in solving the problems of to-day. Such a 
treatise would have dwelt at length upon the proper man- 
agement of slaves, and the principles governing their value. 
It would have paid slight attention to the principles gov- 
erning wages, since free labor was comparatively unimpor- 
tant in ancient Greece. It would have devoted very little 
space to capital and interest, as capital was slightly devel- 
oped, and the taking of interest an infrequent phenomenon. 
Even exchange value, or price, would have received scant 
attention, since most commodities were consumed by the 
producer, instead of being placed on the market, as to-day. 
So we may assume that the economic science of the present 
day will, some hundred years hence, prove almost devoid 
of practical interest. The economics of each generation 
must be based upon the prevailing system of wealth pro- 
duction and distribution. 

15. The fundamental characteristic of the existing eco- 
nomic system is that men produce goods, not for their own 
use, but for sale. 

Throughout the periods of savagery and barbarism men 
lived in small groups, which produced, through the chase, 
agriculture, and pasturage, practically everything that the 
members of the group consumed. Whether the group 
prospered or fared ill depended upon the weather, the fer- 
tility of the soil, the quantity and character of game, the 
relation to other groups — whether tribute was given or 
received. Within the group the relative welfare of each 
member depended to a certain extent upon his own prowess 
and efficiency ; perhaps to a greater extent upon the tribal 
customs in accordance with which the common products 



THE NATURE OF ECONOMIC SCIENCE 13 

of the group were distributed among its members. In the 
civilized states of antiquity a somewhat similar condition 
of affairs existed. Industry was based on slavery; the 
lord of landed estates produced by slave labor almost 
everything that was needed on the estate. His welfare 
depended upon the amount and fertility of the land he 
possessed, the number of his slaves and his skill in man- 
aging them, the state of the weather, and freedom from 
hostile invasion. So, also, in the mediaeval villages. They 
were self-sufficing ; the welfare of the community depended 
upon natural forces and the energy of the members of the 
community and their capacity for cooperation. Each in- 
dividual depended for his welfare partly upon the same 
conditions, partly upon village custom in the apportion- 
ment of services and rewards. 

With the rise of modern trade a significant change took 
place in economic life. In greater and greater measure 
men engaged in production for distant markets, instead of 
for their own use. Under such conditions welfare de- 
pended not only upon the producer's energy and success 
in the creation of goods. It depended also in large meas- 
ure upon the price of the goods which were sent to market. 
The transition from production for one's own use to pro- 
duction for the market took place at various times in 
different countries and in different industries. In some 
branches of production it is only recently that the change 
has been effected. Thus the production of bread, formerly 
almost everywhere carried on in the household for con- 
sumption there, has in the cities become an independent 
branch of industry, carried on for supplying a market, just 
as the production of shoes, cloth, or iron. 

The striking characteristic of modern economic life, then, 
is that men produce goods for the market. The employee 
in a shoe factory will very probably never wear any of the 
shoes he helps to produce ; if the maker of clothes ever 



14 INTRODUCTION TO ECONOMICS 

works on garments for himself, this is the exception to the 
rule of his daily labor. The farmer consumes little, if any, 
of the wheat that he raises ; the woolgrower rarely spins 
and works up into cloth for his own use the product of his 
flocks. The modern economic system is therefore called 
an exchange economy, for it is through exchange of goods 
that each man gets the commodities that he needs. And 
with the rise of the exchange economy a new set of laws 
of wealth and welfare have come into operation. The 
welfare of a farmer under modern conditions depends in 
some degree upon his own energy and intelligence, and in 
some degree upon the weather. But in a very large de- 
gree it depends upon the price at which he can sell his 
products. A high price of iron brings prosperity to all the 
classes engaged in the production of iron, as a low price 
involves them in loss and distress. 

16. A second characteristic of the modern economic system 
is competitio7i in the sale and purchase of goods. 

When men first began to produce goods for sale, we may 
suppose that they had fairly definite views as to the mini- 
mum price they would take and the maximum which they 
might reasonably seek, and that the margin between mini- 
mum and maximum was not wide. At any rate we know 
that in mediaeval times the producer was animated by the 
ideal of a fair and just price; to demand more than this 
was extortion ; to accept less was a humiliation. This spirit 
prevailed, however, only in dealings with fellow-townsmen. 
To comriel strangers to pay more than a fair price, and to 
force strangers to accept less than a fair price for their 
wares, was regarded as entirely legitimate. As trade de- 
veloped it assumed more and more the character of trade 
between strangers, each party to a transaction seeking to 
gain the largest possible benefit from it. 

Naturally that buyer was in the most favorable position 
who could pit one seller against another. Each seller would 



THE NATURE OF ECONOMIC SCIENCE 15 

be forced to scale down his prices lest the other seller con- 
summate an advantageous bargain. Similarly, that seller 
was fortunate who could pit one buyer against another. 
This was competition in its crudest form. In this form it 
exists to-day in auction rooms, stock exchanges, and in cer- 
tain branches of retail trade. 

A seller may find himself alone in the presence of a 
buyer, yet both may be subject to the influence of compe- 
tition. The seller knows that the buyer can probably find 
another seller of the same or similar wares ; the buyer 
knows that the seller can find other buyers. Accordingly, 
the action of each is controlled, in a measure, by the possi- 
ble action of persons who are not present and have no 
knowledge of the particular transaction in which they are 
engaged. This form of competition is more or less effec- 
tive according to the number of transactions of a given 
kind occurring in a community. No grocer can sell sugar 
for a price much in excess of that fixed by other grocers ; 
no farmer can hold out for an excessively high price for 
his wheat. The seller of an old mansion is less narrowly 
limited in his demands by competition of this kind, as the 
buyer must choose between the mansion and some other 
kind of house. On the whole, it may be said that with the 
development of industry a constantly greater proportion of 
the goods bought and sold are of such a character that 
competition enters into the determination of their prices. 

Competition may assume a yet subtler form. In small 
towns petty dealers often evince a spirit of hostility to 
the occasional circus, because the circus "takes money 
away from the town." It is clear that the money spent at 
the circus cannot be spent for candy and soda water and 
other similar goods. The circus is thus really a competitor 
of the petty trader. The latter must give goods of better 
quality, or goods at lower prices, to prevent pennies from 
being hoarded for circus day. The principle involved in 



16 INTRODUCTION TO ECONOMICS 

this illustration is that every seller is a competitor of every 
other seller; every buyer of every other buyer. An ex- 
change economy inevitably entails competition. 

17. Competition is always subject to more or less conscious 
restraint. Where this restraint is effective, monopoly exists. 

In mediaeval and early modern times the producers and 
traders of each town claimed the right to exclude strangers 
from buying or selling within the town, except under re- 
strictions that effectively prevented them from competing 
for the ordinary trade of the town. Each citizen was com- 
pelled by law and custom to refrain from acts that would 
impair his fellow-citizens' chances of securing " fair prices." 
Early modern trade with barbarous and half-civilized peo- 
ples was also carried on under regulations calculated to 
restrain competition. Each European country claimed the 
exclusive right of trading with certain regions — Spain 
with Spanish America, England with British America and 
parts of the East Indies, Holland with the Dutch East 
Indies, etc. Nor were all citizens of these countries 
permitted to participate in the trade with their respective 
colonies ; companies of traders were formed and were 
given exclusive privileges, insuring them the benefits of 
non-competitive conditions. In recent years every modern 
nation has witnessed the formation of combinations of pro- 
ducers with the object of limiting competition. Many of 
these combinations are successful in controlling, to a certain 
extent, the prices of their products. These combinations 
are popularly known as monopolies. They are none the 
less subject to the form of competition last described in 
the foregoing section. 

18. A third characteristic of the modern economic system 
is the formation of classes based upon economic function. 

Every society which has passed beyond the most primi- 
tive stage has been composed of classes. Master and slave, 
lord and serf, Norman and Saxon — such are some of the 



THE NATURE OF ECONOMIC SCIENCE 17 

class distinctions with which history has familiarized us. 
Under modern conditions class distinctions are formed on 
other lines. One class of men gain their livelihood by labor ; 
another by the ownership of property ; a third by placing 
labor and wealth in productive combinations — laborers, 
capitalists, and enterprisers. This differentiation of classes 
is by no means complete, and probably never will be. 
Most laborers own a little property ; most capitalists per- 
form labor; most enterprisers are at the same time both 
laborers and capitalists. Nevertheless, the differentiation 
is clearly enough marked for all practical purposes. It is 
a natural result of modern conditions of production. So 
long as each man produced goods for his own use, the 
tools and appliances which he used were of necessity sim- 
ple. To cut enough wood for one's own use did not re- 
quire a very expensive ax; to furnish boards for one's 
own dwelling required only a handsaw, to be worked by 
two men. Spinning wheels and looms were likewise of 
the simplest make. These tools and appliances could be 
made by the workman himself, or secured through ex- 
change at small sacrifice. Accordingly, the laborer as a 
rule owned the implements he worked with. In early 
modern times, although production for the market had be- 
come fairly common, the means of production still remained 
in the worker's hands. The increasing demand for prod- 
ucts, however, soon led to the introduction of more ex- 
pensive tools, and at last to the invention of machinery. 
Every step in this direction made it more difficult for the 
worker to provide himself with the means of production. 
So these had to be supplied by persons of wealth — capi- 
talists. Under present conditions manufacturing industry 
in almost all its branches requires so large an expenditure 
for equipment that no single laborer can work with his 
own tools and machines ; nor is it possible for a group of 
laborers to equip themselves for production through com- 



1 8 INTRODUCTION TO ECONOMICS 

bining their small savings. The capital outlay for a mill 
employing a hundred workmen is usually far in excess of 
what a hundred workmen can accumulate. Industry must 
therefore be conducted by wage laborers and employer- 
capitalists. In many cases those who possess capital are 
not in a position to use it in business. These persons form 
a 1 class fairly distinct from those persons who actively en- 
gage in the conduct of business. 

19. The laws of price are the governing principle in mod- 
ern economic life. 

A farmer or a manufacturer is popularly said to " put a 
price " upon his products. In the majority of cases, how- 
ever, what the seller really does is to make a choice be- 
tween selling at a given price or keeping his goods unsold. 
Except in comparatively rare cases there is a market price 
for goods which the buyers and sellers must accept if they 
desire to engage in business at all, and over this price 
no single person has any perceptible control. Yet prices 
do not exist apart from the action of men ; they are the 
creation of man in society. Many persons, each acting 
with a view to his own interest, offer wheat for sale ; 
many persons stand ready to buy it. The price of wheat 
is fixed as a result of the offers and purchases of all per- 
sons who buy or sell wheat. It is therefore a social phe- 
nomenon — the creation of all society, or of a large part of 
it. And so it is with almost all prices. They are set by 
society. Hence the laws of price are properly called the 
laws of social economics, or of political economy. 

Under modern conditions the prosperity of each in- 
dustry as a whole depends largely upon the prices of its 
products. Within each industry the prosperity of each 
laborer, capitalist, or employer depends in great degree 
upon the way in which the total product of the industry 
is divided. And here again we encounter social laws. 
There is a general rate of wages, which the laborer must 



THE NATURE OF ECONOMIC SCIENCE 19 

accept if he wishes employment. In the same way, there 
is a general rate of interest. No one man exercises any 
appreciable influence in fixing these rates; they are the 
resultant of the actions of all those who have labor to sell 
or capital to lend, on the one hand, and on the other hand, 
of those who desire to hire laborers or to borrow capital. 

The influence of price extends even further. In large 
measure the laws of price determine what each of us shall 
do ; they fix one's place of residence as well as his occupa- 
tion. If the price of glass is high, and remains high for a 
considerable period of time, high profits and high wages 
are possible in the glass industry. New establishments 
will be opened ; boys and young men who otherwise 
would have engaged in other industries become glass blow- 
ers. By fixing a high price on glass, society, as it were, 
decrees that more persons and more capital shall be de- 
voted to that industry. If coal and other sources of power 
are exceptionally cheap in a given locality, if conditions of 
transportation are exceptionally favorable, large profits 
may be made by manufacturers in that locality ; they 
increase their investments and new capital flows in from 
less favored districts. A city is built, and the population 
that was formerly scattered in hamlets and country is under 
a sort of compulsion to congregate there. Why are our 
cities becoming greater and greater ? The social laws of 
price decree it. If we would understand just why modern 
society presents a given form, our inquiry must take into 
account, as perhaps the most important factor, these laws 
of price. 

20. Summary. 

Economics is the science which treats of wealth — the 
material objects and human services which contribute to 
human welfare, and are therefore valued. The history of 
mankind is largely a record of progress in the power of 
producing wealth and the development of institutions for 



2 o INTRODUCTION TO ECONOMICS 

the distribution of wealth among the individuals composing 
society. 

Economic science begins with a study of the desires 
which give rise to economic activity and the values which 
originate in these desires. It deals, further, with the gen- 
eral laws governing the production of wealth and its distri- 
bution among the various classes in society. The practical 
object of the science is the establishing of principles upon 
which organized society must act in order to increase the 
general well-being. 

The economic problems of any historical period can be 
understood only with reference to the underlying condi- 
tions characterizing the economic life of that period. In 
order to appreciate the significance of modern economic 
problems, it is necessary to ascertain the fundamental char- 
acteristics of modern economic life. These are: (i) Pro- 
duction, of goods and services, not for the use of the 
producer, but for sale; (2) Competition in the purchase 
and sale of goods and services; (3) The existence of 
classes based upon economic function — laborers, capital- 
ists, and enterprisers. The last two characteristics are, in 
a sense, corollaries of the first. 

The key to an understanding of the existing economic 
system is to be found in the laws governing the prices of 
commodities and services. The prices of goods are for the 
most part beyond the control of individuals ; they may be 
said to be determined by society as a whole. The laws of 
price are therefore properly described as social laws ; and 
the body of thought dealing with these laws is known as 
social economics. 



CHAPTER II 
UTILITY, VALUE, AND PRICE 

1. Economic evolution is, in large measure, dependent 
ttpon the development of wants. 

Man is distinguished from all other living creatures by 
the number and complexity of his wants. The lowest 
savage requires better shelter and more varied and nutri- 
tious food than his next of kin in the animal world. The 
wants of the savage are, however, few and simple as com- 
pared with those of civilized man. An extraordinary run 
of fish, an exceptionally good season for game, may leave 
the savage with all his wants practically satisfied. Men 
who have had occasion to employ workmen of half -civilized 
races complain that as soon as the workman has received 
wages enough to supply his wants for a few days, he 
ceases to take interest in his work, and very soon quits 
his employment, to resume it again only when driven by 
the goad of hunger. Civilized man, on the other hand, 
seldom suffers from lack of means to satisfy hunger; he 
is, however, constantly aware of some want that remains 
unsatisfied, and the higher the state of civilization, the 
greater the number of wants that are effective enough to 
incite a man to activity. The normal man in an American 
city limits his toil only when he feels that this is necessary 
in order to preserve his powers for future labor. Even our 
pleasures are selected largely with a view to increasing our 
working capacity. 

Not only do the wants of civilized man impel him to 
work harder than a savage would work; they also force 
him to take more careful thought in the application of his 
energies. Hence the invention of new appliances for pro- 

21 



22 INTRODUCTION TO ECONOMICS 

duction and better methods of organizing and directing 
productive power. As a rule, the more numerous and 
complex the wants of an individual, the greater are his 
exertions and the higher the skill and intelligence with 
which his energies are directed. 

2. Human wants differ widely in elasticity, the wants 
for luxuries being more elastic than the wants for neces- 
saries. 

Every want of man is capable of complete satisfaction. 
But the different wants vary widely in their insistency and 
in the ease with which they may be entirely satisfied. The 
want for bread, for instance, is extremely insistent, yet easily 
satisfied. I must have bread, but I would not care to have 
even a petty baker's entire supply. Such a want is known 
in economics as an inelastic one. The people of the United 
States require a fairly determinate quantity of wheat for 
food, and this quantity they will strive to secure even at 
great sacrifice. Much more than this, however, would not 
be wanted at all, unless of course it could be sold in other 
lands, or some use other than the supplying of food could 
be found for it. On the other hand, the want for some 
classes of things is very hard to satisfy at all, although 
it is not absolutely essential that the want be satisfied. 
I can get on very well without possessing paintings, but I 
should like to have all there are in the Louvre. The peo- 
ple of the United States may live comfortably without 
having many art galleries, but it is almost inconceivable 
that they could have too many. Such wants, then, are 
elastic. 

As the examples given indicate, it is the wants for so- 
called necessaries that are inelastic ; the wants for luxuries 
are elastic. Civilization tends to develop the wants for lux- 
uries of all kinds. Hence, it may be said that the higher a 
people stands in the scale of civilization, the farther it is 
from the complete satisfaction of all its wants. 



UTILITY, VALUE, AND PRICE 23 

3. When a want is satisfied by the consumption of a suc- 
cession of similar goods, the satisfaction derived from the 
first good consumed is greater than that derived from the 
second, and that derived from succeeding goods grows 
steadily less. This principle is known as the law of dimin- 
ishing intensity of wants. 

Every man wants enough food to keep him alive; a 
quantity sufficient for this purpose he desires intensely. 
An equal additional quantity will keep him in good condi- 
tion ; this quantity he desires only less intensely. Give him 
more food ; it may still please his palate, and satisfy a want. 
But a point is soon reached where the man wants no more 
food at all. 

So the want for a suit of clothes is hardly less insistent 
than the want for food enough for life. A second suit of 
clothes would be highly desired, even if of identical quality, 
as it may be worn when the first is soaked with rain or 
otherwise out of condition for wear. A third suit of the 
same kind would not be desired very intensely ; a fourth, 
or at any rate a fifth or sixth, would be a superfluity. But 
if it is possible to vary the quality, the want becomes far 
more expansive. The social element becomes predomi- 
nant ; the man would dress at least as well as men in the 
social group to which he belongs, or of which he desires 
to become a member. Yet a point is eventually reached 
where neither increase in quantity nor improvement in 
quality is desired. 

It may then be stated, as one of the general laws of 
human nature, that each want is capable of varying degrees 
of satisfaction, that with each increase in the means of 
satisfaction the desire for additional means grows less, 
until a point is reached where want is no longer felt. 

4. The capacity of a good for satisfying wants is known 
as utility. 

Whatever satisfies a want is a good, in economic termi- 



24 INTRODUCTION TO ECONOMICS 

nology. The power of a good to satisfy wants is utility. 
It is, of course, plain that nothing has utility in this sense 
unless it is wanted. Utility is strictly parallel with want; 
human want for a certain object endows it with utility, 
and the degree of utility is measured by the degree of 
want. Before men knew the use of iron, iron ore had no 
utility at all ; with every advance in the art of metallurgy, 
the utility of iron ore has increased. In the days of Marco 
Polo, the only utility that existed in the petroleum of Asia 
Minor arose from its use " to anoint camels suffering from 
the mange"; now the progress of science and industry 
has endowed the same material with a very high utility. 

The same object may have far greater utility under one 
set of circumstances than under another. A tree on a 
mountain side may have utility as it stands, derived, of 
course, from some prospective use. This utility may be 
called elementary utility. When the tree is felled and car- 
ried by a stream to a saw-mill, its utility is increased by 
mere change of place. This addition to the utility of the 
tree may be called//^*? utility. A further increase in util- 
ity appears when the log is transformed into boards. This 
increase is known %.§form utility. If the boards should be 
kept in a lumber yard for ten years, very likely, on account 
of the failing supply of timber, their utility would be con- 
siderably increased. This increase may be called time 
utility. It is to be remembered, however, that the forego- 
ing terms do not represent different kinds of utility, but 
relate to the conditions under which utility comes into exist- 
ence, Utility is the single, uniform quality of want-satis- 
fying power. 

Utility, it is to be borne in mind, is not usefulness. 
Opium prepared for smoking, being ardently desired by 
the victims of the opium habit, has a very high utility, in 
the economic sense ; but it is the reverse of useful. As a 
rule, whatever is useful has utility, but there is no close 



UTILITY, VALUE, AND PRICE 25 

correspondence between the degree of usefulness and the 
degree of utility. 

5. When a man acquires goods of the same kind one by 
one, the utility of the first good acquired exceeds that of the 
second, the utility of the second good exceeds that of the 
third, and so on, each successive good representing a smaller 
titility. This principle is known as the law of diminish- 
ing utility. 

We have seen that wants are capable of varying degrees 
of satisfaction. As utility is strictly parallel with want, 
concrete goods, satisfying the different degrees of want, 
have different degrees of utility. Three bushels of wheat 
may supply me with bread enough to sustain life through 
a year; the utility of these three bushels — supposing I 
have no other source of food supply — is exceedingly great ; 
I want them as I want life and all that life contains. It 
would not be easy to fix an estimate upon this amount of 
utility, but let us call it iooo^r. Another three bushels 
would enable me to keep in fairly good physical condition; 
but their utility to me is evidently less ; perhaps it would 
be ioo;r. Another three bushels might mean overfeeding; 
yet some persons are desirous of being overfed ; hence I 
may still desire these three bushels, and thus endow them 
with utility, which may possibly be measured by 10 x. 
With another three bushels I might feed a cat and a dog ; 
it would give me pleasure to have these as pets ; therefore 
I should desire the additional supply of wheat, and it 
might represent a utility of 5 x. An additional three bush- 
els I could probably not use in any way giving me satis- 
faction. They would have no utility for me at all. 

Suppose that I find a particularly beautiful seashell. 
As it seems beautiful to me, it has utility to me. The 
amount of utility may equal \oy. Another shell will not 
be so much of an acquisition, but I shall still desire it. 
Its utility may perhaps be gy. Additional ones will give 



26 INTRODUCTION TO ECONOMICS 

me less pleasure, but as the want for things of beauty is 
hard to satisfy, I may still experience a desire for a hun- 
dredth or a thousandth shell, and these would have some 
utility for me. There is, however, a point beyond which 
additional shells would merely cumber my premises; 
they would then have no utility. 

These examples assume, of course, that I do not undergo 
a change while I am acquiring these goods. If repeated 
examination of the seashell inspires me with an increasing 
sense of its perfection of form, I may desire a second even 
more than I desired the first. Its utility will be greater 
than that of the first originally was, but not greater than 
the utility of a first shell would be in my present state. 

So one's first experience of classical music may be less 
enjoyable than his second experience of the same kind of 
music. He has, in the meantime, become a more cultured 
person. But assuming that no opportunity for develop- 
ment in taste is permitted, the pleasure derived from the 
first hour of listening to good music will be greater than 
that derived from a second successive hour of equally good 
music. The utility of the second hour of music is less. And 
so we may accept it as a general rule that the utility of a 
unit of any kind of good diminishes as the number of such 
units in one's possession increases. 

6. The want-satisfying pozver of the least important unit 
of a commodity in one's possession is termed the fitial or 
marginal utility of that commodity. 

In the foregoing examples it has been assumed that the 
quantity of the goods increased until no desire for further 
units existed. Most of the things which we desire are not 
to be had in superfluous quantities. Instead of having 
five units, each consisting of three bushels of wheat, let us 
assume that I have but three. The third unit would still 
have a utility of \ox. As this is the utility of the last or 
final or marginal part of my supply, it is called final or 



UTILITY, VALUE, AND PRICE 27 

marginal utility. Suppose that I have only ten seashells, 
and that the utility of the tenth is $y. In economic lan- 
guage 57 is the final or marginal utility of seashells. 
Final utility, it is clear, is a very variable quantity ; if the 
desire for a good increases, with no increase in the num- 
ber of units of the good, final utility increases ; if the de- 
sire remains the same, but the number of units of the good 
diminishes, final utility again increases. In the first ex- 
ample, if the third unit of wheat were destroyed, the 
marginal utility of wheat would at once become 100 x. 

Conversely, marginal utility diminishes with decrease 
in want or increase in number of units. I might tire of 
collecting seashells, or the waves might wash up a wagon- 
load of them. In either case the marginal utility would 
shrink — perhaps to zero. 

7. In effect, the importance of any unit of a commodity is 
determined by the want-satisfying power of the marginal 
unit. The importance of a unit, thus determined, is termed 
its effective utility. 

But does any man really arrange his wheat or other 
goods in series of units and say to himself : " This unit is 
worth ioocr; without it I should starve; this unit is 
worth ioojt, as my comfort and strength depend upon it; 
this unit is worth 5 x, for if I did not have it I should be 
compelled to do without my pets"? Not at all; the dif- 
ferent units are just alike, and one is thought of as just as 
desirable as another. For practical purposes, the utility of 
one unit is the same as that of another. Let us suppose 
that there are four units of wheat, and that the last has a 
utility of 5 x. What is lost if any one of the four units is 
lost? Simply $x. What sacrifice would one make to 
prevent the loss of any unit, even the one which would 
have been used to sustain life, and by itself would be 
worth 1000^? A sacrifice not greater than $x. For if 
any other unit is lost, the least important one will be sub- 



28 INTRODUCTION TO ECONOMICS 

stituted for it, and the effective loss will be properly placed 
at $x. 

The utility of the last and least important unit, then, 
exercises an important influence in determining what util- 
ity one will in effect ascribe to any unit. For practical 
purposes the utility of any unit is exactly equal to that of 
the least important one. The utility of a unit, thus meas- 
ured by that of the least important one, is called " effective 
utility." 

If the total number of units of a good is so great that 
the last one has no utility, the good has no effective utility 
at all. No one will do anything to prevent the destruction 
of part of his supply ; no one will give anything to in- 
crease his supply. Thus water, although a single gallon 
would have indefinitely great utility if this were the only 
gallon available, is in most places so abundant that the 
last units of the supply have no utility. Therefore no 
unit has effective utility. 

8. A knozvledge of the comparative effective utilities of 
different goods is essential to the rational application of 
means for the production or acquisition of goods. 

Almost every one who is about to engage in the produc- 
tion of wealth has several options as to the kinds of goods 
he may produce and as to the qualities or grades of each 
kind. A farmer may produce wheat or corn, cattle or 
hogs ; he may produce a hard grade of wheat or a soft 
one ; he may produce thoroughbred stock or grade stock. 
Every man who is at the point of making a purchase has 
numerous options as to the goods upon which he is to 
spend his money. Some options, naturally, offer greater 
advantages than others. 

Suppose that a cultivator can produce, with the expen- 
diture of one day's labor, two bushels of potatoes or one 
bushel of wheat. Should he spend his time in producing 
wheat, or potatoes, or both ? If the effective utility of two 



UTILITY, VALUE, AND PRICE 29 

bushels of potatoes is greater than that of a bushel of 
wheat, the rational thing for him to do is to produce more 
potatoes and to spend less time producing wheat. In ac- 
cordance with the law of diminishing utility, the effective 
utility of potatoes will decline as their quantity increases ; 
at the same time, that of wheat will increase, as our ex- 
ample assumes that labor formerly occupied in wheat pro- 
duction is diverted to the raising of potatoes. A point 
will probably be reached where a day's labor will produce 
as much utility in one branch of agriculture as in the 
other ; and until this point is reached, the cultivator has it 
in his power to increase his welfare simply by making a 
more rational distribution of his labor. 

But before one can rationally distribute his labor or 
other resources, he must have a definite notion of the 
relative effective utilities of goods. He must measure the 
utility of one — the degree to which it seems desirable to 
him — in terms of the utility of another ; or he must 
measure them all by a common standard. And this, of 
course, is easy to do. Think of any two objects. Which 
seems the more desirable? That one has the greater 
utility for you. How far would you walk in order to get 
good No. 1 ? If you would walk twice as far to get good 
No. 2, the latter has, for you, twice the effective utility of 
the former. Any good, or any sacrifice, may serve thus 
as a standard for measuring the comparative utilities of 
goods. Under existing economic conditions, of course, the 
standard which most readily occurs to one is money. If 
one wishes to compare the utilities of wheat and potatoes, 
he naturally considers how much money he would give for 
a bushel of either. 

9. The utility of a good, measured by some standard, 
either of utility or sacrifice, is personal value. Personal 
value varies from individual to individual, and is constantly 
fluctuating. 



30 INTRODUCTION TO ECONOMICS 

Now, the effective utility of a commodity, compared with 
that of some other commodity, or compared with some 
sacrifice which serves as a standard, is personal or " sub- 
jective " value. Value in this sense of the term is effective 
utility measured. And as effective utility is constantly 
fluctuating with changes in the amount of a good, or in the 
desire for it, personal value is also always fluctuating. 

We often hear of the " real " value of a thing, or of the 
" intrinsic " value, as if there were some kind of value resi- 
dent in a thing apart from man's desire for it. Of course, 
there can be no such thing. The value of a thing to any 
person is its importance at a given time and place. 

Values will naturally be different for different persons. 
What is the value of my grandfather's watch ? To me, it 
may be equal to that of $1000. Perhaps you would not 
give $10 for such an antiquated timepiece. In less extreme 
degree the same thing holds of every good. Some will 
place a high value upon an object ; others a low value ; and 
the one is as properly the true or intrinsic value as the 
other. 

But is there not a certain scale of values in which most 
persons agree, and has not this general value a claim to the 
title " true value " ? There is indeed something like a scale 
of values established, as it were, by common consent ; and 
the economic activities of each are, as it were, directed 
toward making his own scale of values conform to that 
of society. How this social scale of values arises out of 
the purely personal values just described, it will be our 
next task to consider. It is of course self-evident that the 
social value does so arise. One cannot conceive of society 
as establishing values and imparting them to individuals. 

10. Personal values are in some measure socialized 
through imitation. 

Utility, as we have seen, is a quality with which an ob- 
ject is endowed by virtue of a human want. This want 



UTILITY, VALUE, AND PRICE 31 

may arise out of personal or out of social need. If a par- 
ticular social need should disappear or change, certain of 
our wants would disappear or change. Certain classes of 
goods, destined to satisfy such wants, would lose their 
value, or undergo some change in it. There was a time 
when gentlemen clipped their own hair and covered 
their heads with wigs. To move in polite society, one had 
to follow this, as other fashions. Hence there was a want 
for wigs, and these were endowed with effective utility and 
value accordingly. As the wearing of one's own hair 
came into vogue, this particular kind of wig ceased to 
have either utility or value. Now it is clear enough that 
the great majority of those who followed the earlier fash- 
ion could have had no personal need nor want for a wig. 
They derived the want from their associates. The custom, 
I suppose, originated with some bald-headed prince, who 
really needed a wig. And so it was transmitted from the 
court to the gentry, and persisted long after the reason for 
its existence had disappeared. The value of wigs thus 
arose from a personal need ; it attained vogue through 
imitation, and, by a similar process, faded out and disap- 
peared. 

Suppose that I attend an auction of the effects of an 
eccentric gentleman, who has led a solitary life collecting 
odds and ends of all kinds, among them some things of 
value. I find a painting that pleases me. Say that I 
know nothing of art, and that all the painting represents 
to me is a group of dull, brutish persons, making unneces- 
sarily hard work out of some simple agricultural operation. 
What is its value to me ? It would be difficult to say ; 
certainly in my own mind the value is something very 
tentative. But finding that the picture can be had for no 
great sum, I resolve to buy it. I hang my acquisition in 
an inconspicuous place, for I am not sure whether I should 
be proud of it or ashamed of it. A friend who knows 



32 INTRODUCTION TO ECONOMICS 

something of art calls on me. Perhaps he takes merely a 
glance at the picture and says nothing. Its value to me 
shrinks to zero. But if he cries enthusiastically, " Ah ! a 
Millet ! " immediately its value to me expands in an ex- 
traordinary fashion ; what had been scarcely a valuable 
object at all becomes a priceless treasure. 

Here then is one reason why values for different per- 
sons tend to conform to the same scale. If I find that 
most of my friends think that a riding horse is dear at 
$300, I think so, too, although I might get more satis- 
faction out of the horse than they. Value is thus in large 
measure a matter of imitation. But before one can 
imitate, there must be something original to serve as a 
center of imitation ; and in the matter of values, this must 
be the original personal value of some, arising out of 
effective utility to them. 

Moreover, though imitation brings about a certain uni- 
formity in the scales of values of different persons, it can 
not of itself make them absolutely alike. If most of my 
friends think that a particular horse is worth $ 200, I cer- 
tainly would not value it at $300, unless indeed I am a 
connoisseur in horseflesh and my friends are not. But I 
may think the horse is cheap at $200, while my friends 
may think it is dear. And this shows that in spite of all 
tendency to conform, I retain a scale of values that is 
peculiarly my own. 

11. The most effective force making for socialization of 
values is exchange. 

So long as men lived in self-sufficing groups, producing 
whatever they needed for their own use, there was no 
other force than imitation which could make the personal 
valuations of one group correspond with those of another. 
But in an exchange economy there is a much more potent 
force making for the socialization of values. 

Suppose that two farmers, with adjoining fields, both 



UTILITY, VALUE, AND PRICE 33 

grow potatoes and wheat, and suppose that they are so 
far from a market that they can exchange their products 
only with each other. Farmer A may consider that a 
bushel of wheat is worth two bushels of potatoes ; Farmer 
B may consider a bushel of potatoes worth two bushels of 
wheat. 

Assuming such a divergence in personal valuations the 
natural result will be, not that they will debate the relative 
justice of their views of value, but that they will trade. 
Farmer A can afford to offer Farmer B two bushels of 
potatoes for a bushel of wheat ; Farmer B can afford to 
accept even a half bushel of potatoes for a bushel of wheat. 
Exactly how much A will at first offer, we cannot say, 
nor is that of much importance. What is certain is that 
he can, and probably will, offer terms that will be accept- 
able to B, and some bushels will be exchanged. 

Now, as A parts with some of his potatoes, the effective 
utility, and with it the value, of potatoes to him increases. 
As he gets more wheat, the effective utility of wheat de- 
clines. And the reverse will be the case with B, who is 
increasing his stock of potatoes and diminishing his stock 
of wheat. It may still be worth while for the two farmers 
to exchange more bushels ; but it is not so much worth 
while as it was at first. In the end, exchange must cease, 
for each will value wheat in terms of potatoes exactly as 
the other does. 

Perhaps Farmer A has land that is very well adapted 
to potato production, while Farmer B's land is best fitted 
for the growing of wheat. In another year A will have 
a superfluity of potatoes and B of wheat, and the process 
of exchange will again be necessary to equalize values. 
So in a developed economic system the value of wheat in 
regions where it is produced tends continually to fall below 
the value of it in regions where little wheat is grown ; and 
this it is that keeps up a constant exchange between dis- 



34 INTRODUCTION TO ECONOMICS 

tant regions. And this constant exchange, in turn, tends 
to eliminate the discrepancies in values. 

Returning to the case of the two neighbors, perhaps A 
has a cow which he does not care to keep, but which B 
would like to have ; while the latter has a harrow which 
he does not need, but the former could well use. Possibly 
A values the cow at twenty bushels of wheat and the 
harrow at thirty; while B values the cow at thirty bushels 
of wheat and the harrow at twenty. Here is a good 
opportunity for a trade. Either one might give the other 
a certain number of bushels of wheat " to boot," in order 
to bring about the trade. At what terms will the exchange 
be made? We cannot tell. Nor will the exchange, at 
whatever terms, affect the relative values placed upon 
cows and harrows by either party to the exchange. It 
would be different if more cows and harrows were to be 
exchanged. In that case the scales of values of the two 
exchangers would tend to uniformity, as was the case with 
the potatoes and wheat. But very likely no further ex- 
changes are to be made. So I may be able to buy for $25 
a coat that I would regard as cheap at $50. Another coat 
at $25, however, might not seem worth more to me than 
$20 ; accordingly, I refrain from buying it. Hence the 
coat which I do buy retains a personal value for me in 
excess of the value placed upon it by the seller. It is a 
value that as a whole refuses to be socialized. A similar 
state of affairs exists wherever one buys single goods, not 
quantities of like units, as in the case of wheat. 

12. Personal values may be mere reflections from social 
values. Such personal values may be called personal or sub- 
jective exchange values. 

In the examples employed in the last section it was 
assumed that both parties to the exchange had personal 
values, arising out of their own wants, for both commodities 
exchanged. This may have been the usual case under 



UTILITY, VALUE, AND PRICE 35 

primitive conditions ; but now, when we produce almost 
exclusively for sale, the seller of a commodity must fix a 
personal value in some other way. Say that I am a dealer 
in women's shoes. For my personal use they have no value 
whatsoever. Yet when a prospective customer appears, 
I have just as definite a value, below which I would not 
sell the shoes, as I should have if I were trading off a pair 
of shoes that I might use myself. Whence do I derive 
this value ? I know that if I do not sell shoes to this par- 
ticular buyer, I shall probably be able to sell them to some 
one else. And I will take no less for them than I think 
some one else will pay. If experience shows me that few 
persons will pay the price, I must alter my personal value, 
or the fashions will change, and I shall have a stock of 
unsalable leather on my hands. 

Now it must be plain that this kind of personal value 
is entirely a secondary phenomenon. It is derived from 
the estimate of other men's personal values, arising from 
personal needs. It has its importance ; but it does not 
explain the values that are actually placed upon goods. 
This explanation lies in the facts of direct personal 
valuation. 

13. Value expressed in terms of money is known in eco- 
nomics as price. 

In one's personal estimate of values one may employ as 
a standard of measurement any object having effective 
utility. The farmer may value a horse in terms of wheat 
or cotton ; the ranchman in terms of cattle ; the fisherman 
in terms of fish. The difficulty with such estimates is that 
they are not sufficiently intelligible to other persons. A 
traveler in the Orient writes that a certain rajah places 
the value of an elephant at 2000 yards of Japanese silk. 
Do you know whether the elephant is dear or cheap ? If 
the valuation were made in terms of silver or gold, we 
should all have a fairly definite idea of the value placed 



36 INTRODUCTION TO ECONOMICS 

upon the elephant, as we are constantly using these metals 
and estimating their importance. In practice, then, values 
are usually expressed in terms of silver or gold money. 
For convenience, economists use the the term " price " as the 
equivalent of money value. There are personal prices and 
social prices, just as there are personal and social values. 
Social prices are practically determined by the action of 
buyers and sellers, and as these commonly meet in a mar- 
ket, social price is called market price. 

14. Market prices tend to a uniformity, and correspond 
with the personal prices of those who are least eager to buy or 
to sell, but who nevertheless succeed in buying or selling. 

Personal values, as we have seen, naturally vary widely 
with different individuals. We need not believe that any 
two persons would affix exactly the same money valuation 
upon a particular horse. One man might value the horse, 
for his personal use, at $500; another at $50. Yet we 
find that for a certain grade of horses there is something 
like a uniform price. Perhaps this price is $250. In such 
case the personal values of $50 and $500 are both ignored. 
They have no influence upon the price actually set. 

Personally I may abhor the idea of ballooning. If I 
were to place a value upon balloons for my own use, it 
would be far less than nothing. Clearly my personal value 
of balloons has nothing to do with their price, which for a 
given grade may be $5000. If I had a mild interest in 
this form of sport I might value a balloon at $1000; yet I 
should not influence their price. Were I so passionately 
fond of ballooning, and so plentifully provided with money, 
as to value a balloon at $100,000, this valuation would 
nevertheless be incapable of raising the price of balloons 
much, if any, above $5000. It is clear, then, that some 
personal values count, and some do not,* in the determina- 
tion of prices as they are fixed in the market. 

To show just what it is that determines what personal 



UTILITY, VALUE, AND PRICE 37 

values count in fixing market prices, we may employ a 
somewhat artificial example which is the common property 
of modern text-books in economics. Let us imagine a 
horse market in which there are six persons with horses to 
sell, and six persons each of whom would like to buy a 
horse. We will assume that the horses are as alike as 
peas, so that each buyer would as willingly have one as 
another. Of course each buyer desires to buy as cheaply 
as possible, and each seller desires the highest possible price 
for his horse. Each buyer has in his own mind a top 
price — the most he would pay under any circumstances — 
and each seller has a bottom price, below which he would 
absolutely refuse to go. Being rational men, the buyers 
carefully refrain from letting their top prices be known ; 
and in the same way the sellers keep their lowest prices a 
close secret. We shall assume the fiction writer's omni- 
science, and set down the top and bottom prices of the 
buyers and sellers respectively, as follows : — 



Buyers 


Sellers 


A $100 


M $90 


B 90 


N 80 


C 80 


O 70 


D 70 


P 60 


E 60 


Q 50 


F 50 


R 40 



How many horses will be sold, and at what price ? Of 
course, if each of the buyers in the first column were shut 
up in a stall with the seller in the opposite column, all the 
horses would be sold, and at different prices. But we 
are assuming that all are in an open yard, and hear one 
another's bids and offers. Under these circumstances no 
buyer will pay more than another, nor will one seller take 
less for his horse than another. What price will actually 



38 INTRODUCTION TO ECONOMICS 

be fixed can be seen by following out in detail the probable 
action of these buyers and sellers. 

Suppose A, a buyer, offers $40 as his first bid. R could 
afford to take it ; but as any of the other five buyers would 
be glad to get a horse at that price, they each offer a little 
more than $40. Competition for this horse goes on until 
the price is raised to $50. At this point two horses may be 
had ; but there are six competing buyers, and the price 
goes higher. Thereupon F, who will pay no more than 
$50, drops out. He can exercise no more influence in de- 
termining the price of these horses than I can in deter- 
mining the price of balloons. Bidding goes on, and the 
price is forced up to $60. Three horses are to be had at 
this price ; but as there are still five buyers the price goes 
above $60, and E drops out. At last the price reaches $70. 
There are now four sellers willing to part with their horses 
at this price; and four buyers willing to pay the price. 
Imagine that bidding goes on, and the price rises to $71. 
D would then drop out, and four horses would be offered, 
with only three buyers. Any one of the four sellers would 
rather sell at $70 than have his horse unsold; bidding 
among the sellers, therefore, forces the price back to $70. 
Under the conditions this price represents an equilibrium 
between the values of the buyers and those of the sellers. 

Let us imagine, however, that before the sale is actually 
effected, another buyer, with a maximum valuation of $1 10, 
appears. The price will then be forced above $70, and D 
will drop out. It will not reach $80, however, for then five 
sellers would compete to meet the needs of four buyers. 
The actual price will be fixed somewhere between $70 and 
$80. If an additional seller, with a valuation of $30, were 
to appear, the number of buyers remaining the same, the 
price would drop below $70, but not quite to $60. 

The seller who is least desirous of selling, but who never- 
theless effects a sale, is known as the marginal seller. The 



UTILITY, VALUE, AND PRICE 39 

buyer who is least eager to buy, but yet succeeds in buying, 
is known as the marginal buyer. 

15. Demand is the volume of purchases of a commodity 
that would be made at a given price. Supply is the vohcme 
of sales that would be made at a given price. Market price 
is fixed at a point which tends to equalize demand and 
supply. 

Every person who reads widely in economic literature, 
frequently encounters the statement that market prices 
are determined by demand and supply. It is therefore 
worth while to ascertain exactly what these terms mean. 
Demand is clearly not synonymous with want or desire. 
We may imagine a Hindoo grain dealer closing up his 
shop because there is no demand for grain, although he 
may be besieged by an army of starving people. Desire 
must be supported by purchasing power before it becomes 
demand. Supply does not mean the existing stock of a 
commodity. There may be a shortage in the wheat supply 
because those who have wheat are holding it for higher 
prices. The owner of a commodity must be willing to sell 
before the stock in his possession becomes part of the 
supply. It is evident that in most instances the lower the 
price of a commodity, the greater will be the demand for 
it and the less will be the supply, and vice versa. The de- 
mand for wheat at ten cents a bushel would be enormous, 
the supply at that price would dwindle to practically noth- 
ing. There must be some price for each commodity that 
will exactly equalize the volume of demand with that of 
supply. This price is the one that will prevail in the 
market. 

At a given time the aggregate demand for wheat at $2 
a bushel may extend to one million bushels ; but the sellers 
of wheat may be willing to place on the market two million 
bushels at that price. Manifestly $2 a bushel cannot be 
the price set by the market, for the owners of the second 



40 INTRODUCTION TO ECONOMICS 

million bushels, not finding purchasers, will offer it for less. 
At a lower price, some sellers will drop out, and some ad- 
ditional purchasers will appear. At $1.50 a bushel, per- 
haps fifteen hundred thousand bushels will be offered, and 
the same amount taken. Then $1.50 is the price that will 
actually be set. 

Those buyers whose personal valuations are the lowest, 
and who would be ready to drop out if the price rose, are the 
ones who at any particular time determine the volume of 
the demand. Those sellers whose personal values are 
highest, and who are ready to drop out if the price falls, 
determine, for the time being, the volume of the supply. 
The principle that the price is fixed at a point which equal- 
izes demand and supply is therefore tantamount to the 
principle, given in section 14, that price corresponds with 
the personal valuations of those who are least eager to buy 
or to sell, or the marginal buyers or sellers. 

16. A particular set of marginal buyers and sellers con- 
trol prices only for a brief time. 

While it is the buyers and sellers who are just ready to 
drop out with changes in price — the marginal buyers and 
sellers — who at a given time hold the price where it is, 
price changes may take place in spite of them, through 
changes in the wants of purchasers, or through the, ap- 
pearance of new sellers. The introduction of the automo- 
bile resulted in a new demand for gasolene, and as a 
consequence the price rose, eliminating the purchasers who 
had before been in a price-determining position. If alcohol 
should be successfully substituted for gasolene for the same 
purpose, the price of gasolene would fall, and a new set of 
purchasers, who formerly had nothing to do with fixing its 
price, as they did not desire it enough to buy it, would 
come to occupy the position of controllers of the price. 

Under existing conditions we do not find ourselves in 
the presence of unpriced goods upon which a price is to 



UTILITY, VALUE, AND PRICE 41 

be placed. Everything that one wishes to buy already 
bears a price ; one accepts the price, or refrains from pur- 
chasing. I compare my personal value of anything — say 
a hat — with the value of the commodity in the market. 
If I decide that a hat is worth more than $5 to me, I pur- 
chase it if it is to be had at that price. As I part with some 
of my money, each dollar I have is worth more to me ; and 
hats are worth less. Thus I make my personal value ap- 
proximate that of the market. If I am a seller of hats, 
and I find that $5 are worth more to me than a hat, I 
willingly part with the hat at that price. As I have 
more dollars, one is worth less to me; having fewer 
hats, I am not so eager to part with one. Thus by buy- 
ing and selling one makes his personal values conform 
more nearly to that of the market. At the same time, by 
taking a hat from the seller, I reduce by a trifle the num- 
ber to be sold to other purchasers ; I make the hat sellers 
less eager to sell, and contribute of my puny strength to 
draw up the general level of value of hats to my own 
personal value. So all of us who are purchasers are 
joining our efforts to raise prices to a high level, although 
what we desire is low prices ; and all of us who are sellers 
are exerting our combined strength to pull them down, 
although we are anxious to have high prices. Those of 
us who are least eager to buy or to sell exercise an equal- 
izing function ; when the buyers' side prevails, and prices 
are rising, the least willing buyers drop out ; and similarly 
with the least willing sellers, when the sellers succeed in 
pulling prices down. 

17. Summary. 

Progress in civilization is attended by an ever increasing 
number of wants. Of these, some are inelastic : though 
often very insistent, they can easily be completely satisfied. 
Other wants are elastic. Complete satisfaction of elastic 
wants is difficult. Wants of the latter class evince the 



42 INTRODUCTION TO ECONOMICS 

greater tendency toward development with the progress of 
civilization. Wants of both classes admit of different de- 
grees of satisfaction ; in the case of every want successive 
increments in the means of satisfaction are desired with 
diminishing intensity. 

Utility is want-satisfying power. Successive increments 
of any good diminish in utility as the want endowing them 
with utility diminishes in intensity. The least important 
of a number of units of a given good is known as the mar- 
ginal unit; its utility is termed marginal or final utility. 
In effect, the utility of every unit of a given good is no 
greater than that of the marginal unit. The utility of any 
unit, thus reduced to terms of that of the marginal unit, is 
effective utility. 

In order that a man may direct his economic activities 
to the best advantage, he must often compare the effective 
utility of one commodity or service with that of another. 
The effective utility of one good thus measured by that of 
another is personal value. Personal values vary from in- 
dividual to individual ; they may, however, be reduced to 
approximate uniformity through imitation or through ex- 
change. When all the personal values in a social group 
have been reduced to uniformity, social values emerge. 
These values, expressed in terms of money, are prices. 

In a market prices are fixed at a level corresponding 
with the personal valuations of those actual buyers who 
are least eager to buy and those sellers who are least eager 
to sell. From another viewpoint, it will be seen that 
prices are established when the amount offered for sale 
just equals the amount sought by purchasers, or, in other 
words, where demand and supply are equal. 



CHAPTER III 
NORMAL COMPETITIVE PRICE 

1. The market price of the most important commodities 
is subject to frequent fluctuations. 

Since prices depend upon the valuations of the mar- 
ginal buyers and sellers, or, what amounts to the same 
thing, upon demand and supply — factors that are con- 
stantly changing — we should naturally expect prices to 
fluctuate. That they do fluctuate is easily proved, either 
by our daily experience in buying and selling, or by an 
examination of price statistics. In the period from May, 
1907, to December, 1908, the price of wheat in New York 
ranged from $0.81^ per bushel to J1.14J. The price of 
corn ranged from 57 cents per bushel to 90 cents; the 
price of cotton, from 8^f cents per pound to 13J cents; 
the price of wool, from 20 cents to 28 cents ; the price of 
copper, from 12.37J cents to 25.50 cents. 

We are, indeed, familiar with a large class of commodi- 
ties the price of which never varies. Postage stamps 
are always sold at uniform prices. Many patented arti- 
cles, especially goods for personal use, and most copy- 
righted books, are sold at unvarying prices. From May, 
1907, to December, 1908, steel rails were quoted at $28 
per ton — never more, never less. The explanation of 
such steadiness in price is always the same — monopoly, 
in one form or another. Where there is but one seller, 
and that seller resolutely refuses to change his prices, 
there can, of course, be no price fluctuations. We shall 
postpone discussion of monopoly prices to the following 
chapter ; in the present we are concerned with the laws 
governing prices in the competitive field. 

43 



44 INTRODUCTION TO ECONOMICS 

2. The prices of perishable commodities fluctuate more 
widely than do the prices of those commodities that are 
relatively imperishable. 

In the cases cited in the foregoing section the most 
marked fluctuation was in copper — a little over ioo per 
cent. But for the fact that the period under consideration 
began with an artificially high price of copper, owing to 
speculative manipulation of the market, and ended with 
an artificially low price, owing to the same cause, the price 
of copper would probably have ranged from 15 to 20 
cents. Such a degree of fluctuation in a staple, non-per- 
ishable commodity is about as great as one can expect, 
even in a much longer period of time. If the price of 
such a commodity declines perceptibly, buyers lay in 
stocks, in expectation of a reaction toward higher prices, 
and by this very means tend to bring on the anticipated 
reaction. The prices of such commodities as strawberries, 
fresh vegetables, and fresh fish may easily advance or de- 
cline 100 per cent in a single week. With progress in 
methods of preserving such commodities, the range of 
price fluctuations is reduced. We do not buy perishable 
commodities at such low prices, nor at such high prices, 
as were known before refrigeration came into common use. 

3. The range of price fluctuations grows less with im- 
provements in transportation and the extension of the 
market. 

In the early part of the nineteenth century England, 
through the policy of levying heavy duties on imported 
wheat, forced her population to rely almost exclusively upon 
the domestic supplies of grain. As a consequence of this 
policy a good season meant very low prices, a bad season 
very high ones. In 18 12 the price of wheat rose to $3.84 
per bushel; in 1822 the price was $1.35. To-day such a 
range of wheat prices is unknown in England. Wheat is 
imported from all quarters of the globe, and it is impos- 



NORMAL COMPETITIVE PRICE 45 

sible that all the world should have a bad season at one 
time. If the American crop is short, it is highly probable 
that the crop in Russia, India, or Argentina will be excep- 
tionally heavy. 

Improvements in railway transportation have made pos- 
sible the carriage of perishable commodities over great 
distances. Fresh fish from the Columbia river on our 
northwest coast are now carried to Germany when the 
prices in the German market are high enough to justify 
the expense of transportation. This keeps the local price 
of fish from falling so low as it otherwise would, when the 
catch is heavy, and keeps the German price from rising 
so high as it otherwise would when the Norway fisheries 
yield a short supply. 

We are safe in saying that modern improvements in 
transportation and market organization tend to eliminate 
sharp fluctuations, limited to a small area, and to substi- 
tute more moderate fluctuations, extending over wide 
areas. 

4. Competitive prices tend toward a theoretical level 
which may be called the normal, since every deviation from 
this level is followed by a reaction. 

At times market prices rest at a level that every one 
knows is too high or too low to be maintained for any long 
period. Such prices we naturally regard as abnormal. 
A certain fabric comes into vogue; everybody must have 
it, and as there is not an indefinite amount of it, the price 
rises. Perhaps it was worth $1 a yard before fashion 
touched it with its magic wand ; the price may easily be- 
come $5. Now, is this price one that is likely to continue 
— even supposing that the fashion should be transformed 
into a custom, and the enlarged demand for the fabric 
should thus become permanent ? Would it be safe for 
one to buy large stocks of this cloth, with the expectation 
of selling them at $5 a yard ? Would it be wise for one 



46 INTRODUCTION TO ECONOMICS 

to put up a mill for the manufacture of this kind of goods, 
with the expectation that the high price would continue? 
There are conceivable conditions under which one might 
prudently do these things ; but in most cases this would 
be very bad business. Most probably, the price would 
sink again toward the $i mark. In all likelihood $i is 
about what that fabric will sell for in the long run. 

If for any reason the price of wheat rises to $2 a 
bushel, we can predict with absolute certainty that the 
number of sellers will go on increasing until the price 
comes down; $2 for wheat is therefore an abnormal, or 
unnatural, price. On the other hand, if the price falls to 
fifty cents a bushel, we may be certain that in time sellers 
will drop out, and the price will rise. Fifty cents is an 
abnormal price, just as $2 is. Between the two prices 
must somewhere be one that is normal or natural. The 
market price will be constantly rising above or falling 
below it ; yet there will always be an increase in selling 
when the price is above the normal, and a diminution in 
the number of sales when the price is below the normal ; 
consequently the price will fluctuate about this point, 
never remaining long much above or much below it. 

So it is with a large proportion of the commodities sold 
on the market. Their prices may at any time double ; 
but in all probability this is a transient phenomenon. If 
anything is sold at an extremely low price — a price that 
has rarely been known before — probably this also is a 
transient phenomenon. And just as it would be bad 
business to buy large stocks, or build factories, in anticipa- 
tion of the continuance of excessively high prices, so it 
would be folly to quit a business, or sell out all one's 
stock, because of excessively low prices. The business 
man who is most likely to succeed is the one who has a 
due appreciation of normal price and who directs his busi- 
ness, so far as it is concerned with a more or less distant 



NORMAL COMPETITIVE PRICE 47 

future, in accordance with its laws. Normal price, there- 
fore, is a phenomenon of the greatest practical importance. 
And in so far as it determines the direction of the produc- 
tive forces of society, it is of the highest importance to the 
student of economics, as well as to the man of affairs. 
This is true even though actual prices may at any given 
time be above or below the normal, and may perhaps 
never remain for an appreciable time at precisely the 
normal level. 

5. The forces which cause prices to hover about a normal 
level originate in the field of production or supply. 

Prices, we have seen, rise or fall in consequence of 
changes either in demand or in supply. The most violent 
fluctuations in price are, as a rule, due to changes in de- 
mand. Consider the fall in price, in the early autumn, of 
summer clothing. Increase in supply has nothing to do 
with this price change ; decrease in demand is the sole 
explanation. Compare the price of a striking style of 
women's hats, at the height of their popularity, with their 
price when another style of hat gains the ascendency. The 
forces of demand originate, in large part, in caprice, indi- 
vidual and social. Were prices determined solely by these 
forces it would be vain to search for a law of normal price. 

The forces governing supply, on the other hand, admit 
of a reasonable degree of calculation. Supply is controlled, 
in a measure, by chance, as in the case of the products of 
the soil, which may be abundant or scarce according to 
the season. Far more important, in the control of supply, 
are the decisions of producers, and these decisions are 
usually the result of calculations, not caprice. A man 
raises hogs or peas or even roses, not because it pleases 
him to do so, but because he thinks it "pays." 

The supply of most commodities may be increased or 
diminished at the will of the producers. Many producers 
are in a position to increase their output by slightly enlarg- 



48 INTRODUCTION TO ECONOMICS 

ing their working force, or by running overtime. Some 
producers are engaged in the manufacture of a number of 
different commodities, or of grades of one kind of com- 
modity. By discontinuing the production of some of these 
and concentrating their energies on a single one, they exert 
an influence upon supply. Moreover, there are always 
some persons who are in doubt whether or not they shall 
enter upon a certain line of production ; still others, now 
engaged in that line of production, are in doubt whether 
or not they shall go out of business. 

When the price of a given commodity is very high, fac- 
tories producing that commodity run on full time, or over- 
time ; factories that would otherwise have produced several 
other commodities turn all their energies in this direction ; 
manufacturers who were in doubt as to whether or not 
they should go on producing, find their doubt stilled ; and 
new producers are lured into the industry. All this 
makes for an increased supply and a falling price. How 
long will the expansion of business continue ? 

6. Normal price is that price which just covers the cost of 
production. 

The two factors determining the business conduct of a 
producer are price and cost of production. In the cost of 
production are included the value of materials used and 
the wear and tear and general depreciation of machinery, 
buildings, lands ; interest on all capital used, whether bor- 
rowed or owned by the producer; wages of all labor, 
whether hired or that of the producer himself ; premiums 
to insurance companies for the assumption of the risk of 
destruction of buildings and stock, or an equivalent return 
for risk if borne by the producer himself ; taxes, water rates, 
etc. If the price of a commodity exceeds its cost, includ- 
ing in the term all the above-named elements, the supply 
of the commodity can be profitably increased. If the price 
just equals cost, there is no sufficient reason for either in- 



NORMAL COMPETITIVE PRICE 49 

creasing or diminishing the supply. If the price is less 
than cost, the supply will diminish. 

Suppose that it costs an average manufacturer $1 to 
produce a yard of woolen cloth. If he can sell it for $1, 
he will probably go on producing about as much this month 
as he did last. For this price enables him to pay his oper- 
atives, to pay interest on capital borrowed, to pay taxes 
and insurance premiums, etc. It also affords him as much 
of a reward for his labor of management as he could get 
if he placed his services at another manufacturer's dis- 
posal; and as large a return on his own capital as he could 
get from any other equally safe investment. But suppose 
the price rises to $1.10. For every yard he can sell he 
gets ten cents over and above all costs. This amount we 
shall call a net profit. Of course he desires to sell as many 
yards as possible. He works his mill to its fullest capacity; 
if he has looms that are nearly worn out, he makes haste 
to replace them with more efficient machinery ; if he has 
been contemplating the erection of an annex to his mill, 
he pushes the work forward as rapidly as he can. Every 
other manufacturer in his line does the same, and in 
time the increased supply of the fabric forces the price 
down, until it reaches $1, where the manufacturer no 
longer has any reason for increasing operations. Possibly 
the price goes still lower and reaches ninety cents. This 
does not pay all costs, but the manufacturer may still con- 
tinue to produce, as it may be better for him to pocket his 
loss than to let the mill stand idle. But it is plain that he 
will curtail operations wherever he can. He will discharge 
his least efficient workmen, and discontinue the use of his 
least efficient machines. Every other manufacturer, in 
greater or less degree, will do likewise. So the supply 
falls away and the price rises toward $1. This, then, 
is the normal price — a price that just covers cost of 
production. 



50 INTRODUCTION TO ECONOMICS 

7. While it may be to the interest of the producers of a 
commodity, as a body, to limit production and so maintain 
prices at a high level, it is to the interest of each individual 
producer to extend his own production. 

If, then, the price of a commodity exceeds cost, forces 
are set in motion which tend to bring the price back to the 
cost level. Now, no producer wishes to sell at cost; every 
producer desires an excess of price above cost, and the 
greater the excess, the better he likes it. If a manufac- 
turer can produce a certain fabric at a total cost of $i, and 
can sell it at $1.10, he enjoys a very comfortable net profit ; 
and the same thing is true of all other manufacturers in the 
same line, and they might continue to secure this net 
profit if each one would refrain from enlarging his out- 
put. There is, then, something illogical in the conduct of 
the several producers, viewed in a certain way. Each of 
them is anxious to get as large a sum of net profit as pos- 
sible ; but the result of their action is that nobody long 
continues to get any net profit at all. 

The reason for this is that there are too many of them 
for any one to have a perceptible influence on price. Sup- 
pose our manufacturer increases his output ioo per cent. 
Probably this would not reduce the price one fiftieth of a 
cent a yard. Therefore he obtains nearly twice as large 
a sum of net profit as he would have done if he had kept 
his output unchanged in volume. The temptation to in- 
crease his output, then, is very strong ; it is strengthened 
by the fact that he knows that every one of the other thou- 
sand producers is subject to the same temptation ; some 
will yield to it, then others, finally all; and those who 
yield first will be the ones who will get the greatest sum 
of profit. Under the conditions, the best thing for the 
manufacturer to do is to yield to the temptation the 
moment it offers. 

And this is what must inevitably occur where competi- 



NORMAL COMPETITIVE PRICE 51 

tion exists — where each producer may increase his output 
if he desires to do so. However much it may be against 
the interests of all the members of a group of producers to 
increase operations, it is to the interest of each one to 
increase his own operations, if the price of his products 
exceeds their total cost. 

Often, in American history, have different classes of 
producers planned a universal curtailment of production, in 
order to force prices above cost level and hold them there. 
At one time the producers of raw petroleum, at another time 
the producers of wheat, at still another time the producers 
of cotton, have beguiled themselves with such plans. If 
each cotton producer would plant ten per cent less ground 
next year, the price of cotton would probably rise twenty 
per cent, and every producer would get more money for 
less labor. Suppose that the cotton producers make a gen- 
eral agreement to this effect. Well, every producer who 
violates his agreement, and doubles his acreage, will get 
the benefit of the high price, and the additional benefit from 
an unusually large quantity to sell. Each producer, having 
his own interest at heart, and suspecting the integrity of 
the motives of others, is under the strongest temptation to 
increase his output. Some will refrain from doing so ; but 
enough will increase their acreage to keep cotton very near 
to cost price. 

But let us suppose that the cotton producers are able to 
bind themselves legally to diminish production, ten, twenty, 
fifty per cent, or that some Croesus buys up all the cotton 
lands and fixes production at the figure which seems most 
profitable to him. In either case, prices will cease to hover 
about cost of production. They will be such as always to 
afford a net profit. Such prices, in contrast with normal 
or competitive prices, are called monopoly prices. They 
are controlled by laws, but these laws are quite different 
from those which prevail in competitive industry. 



52 INTRODUCTION TO ECONOMICS 

8. Deviations from the normal level of prices are quickly 
or slowly corrected according to the ease or difficulty with 
which expansion and contraction of production take place. 

If one out of a number of grades of ordinary cotton cloth 
rises to an abnormally high price, the supply of that grade 
of cloth increases almost immediately. The labor and ma- 
chinery that have been employed in producing other grades 
are diverted to the production of the grade that is in de- 
mand. A few weeks or months probably suffice to bring 
the price back to the normal level. If the price of all grades 
of cotton cloth rises above the normal, a longer period of 
readjustment is necessary. New factories must be built ; 
new workers trained for the industry. If the industry has 
been long established, indeed, expansion can take place in 
less time than would be required if the industry were newly 
established. Let us say that there are, in a long established 
industry, iooo mills producing the same grade of goods 
and selling them in a common market at a uniform price. 
Fifty of these mills become so dilapidated each year, 
through age, that they are dismantled ; fifty mills of equal 
capacity must be put up each year in order to maintain a 
constant supply of goods. If prices are so low that not all 
costs of production are covered, no new mills are erected 
to take the place of those which are abandoned, and a part 
of the supply fails. If prices are above cost, instead of 
fifty new mills, there may be ioo, and the increased supply 
tends to draw prices back toward the cost level. In a new 
industry, on the other hand, there are no old mills to dis- 
mantle when prices fall, although new mills may be erected 
when prices rise. 

9. In agriculture, the uncertainties of the seasons often 
interfere with the operation of the laws of normal price. 

If the price of wheat is high this year, more than a 
normal acreage will probably be sown to wheat next year. 
The average yield per acre may be low next year and the 



NORMAL COMPETITIVE PRICE 53 

price of wheat may remain high, thus inducing farmers to 
sow a still larger acreage the year following. A succession 
of good years may then ensue, with the result that prices 
become abnormally low and the wheat acreage is much 
reduced. In fact, so uncertain are the seasons that 
farmers often fail to recognize that a given crop is being 
produced in excess of the demand at remunerative prices. 
Each season's low prices come upon the farmer unawares. 
He probably ascribes them to some cause other than the 
true one, and continues in his course of over-production, 
perhaps for years. Conversely, high prices may be 
ascribed to false causes — speculation, failure of crops 
abroad, etc. — and consequently fail to set in motion the 
corrective influence of expanding supply. It is only by 
keeping in view a number of years that we can discern a 
normal price level for agricultural products. 

10. Deviations from the normal price level are greatest 
where production requires antecedent preparations extending 
over a period of years. 

Every one who has lived in a fruit-growing country has 
had his attention drawn to the extraordinary returns some- 
times secured by the owners of orchards. In parts of 
California the product of a cherry orchard may be sold, 
on the tree, for $200 or more per acre, and a failure of 
the cherry crop is a rare occurrence. Land similar to 
that upon which the cherry trees are grown was recently 
to be had at $1 50 an acre ; the cost of planting an acre, and 
caring for the young trees up to the time when they be- 
come productive, would probably be covered by an equal 
sum. A $200 return on a $300 investment looks very at- 
tractive, certainly. Why do not more persons enter the 
business of cherry production ? Because several years 
must elapse before they can secure any returns, and in the 
meantime the price of cherries may fall so low that there 
would not be even a fair return in their production. 



54 INTRODUCTION TO ECONOMICS 

In 1885 a Nebraska landowner planted 200 acres of 
catalpa trees. In 1907 he cut the trees and sold the 
product — posts, telephone poles, and wood — for a sum 
which, after paying at a liberal rate for all labor in the 
care of his trees and in cutting and marketing them, yielded 
over 10 per cent compound interest on his original outlay 
for land and for planting. This is an unusually high re- 
turn on landed investment in that part of the country. 
Why then do not more men plant catalpa trees ? Well, 
who can foresee the prices that will prevail twenty years 
hence ? It is entirely conceivable that for a hundred 
years or more those who plant trees will receive an abnor- 
mally high return on their investments. On the other 
hand, the business of tree planting may easily be carried 
to an extreme, with the result that for a long period of time 
those who plant trees will receive practically no return. 

11. Where several commodities are the result of a single 
process of production, it is impossible to determine the cost 
of each one separately. The group as a whole has a normal 
price ; the separate commodities have not. 

Some commodities are invariably produced together, as 
beef and hides, cotton and cotton seed, wool and mutton. 
In most great industries, it is found possible to make use 
of parts of the raw material that are ordinarily regarded 
as waste. Thus, in the refining of petroleum, besides the 
main product, kerosene, a host of by-products — gasolene, 
lubricants, tars, dyes, etc. — are produced. How much 
does it cost to produce these ? Nobody can tell. They 
could not be produced at all, in commercial quantities, 
were it not for the immense capital engaged primarily in 
the production of kerosene. Part of the cost of the use 
of that capital ought to be counted as cost of by-products. 
But it is not possible to say how great that part should be. 
No one can say how much it costs to produce hides, or 
cotton seed, or wool. There is, of course, an ascertainable 



NORMAL COMPETITIVE PRICE 55 

cost, and hence a definite normal value, of live cattle, of 
sheep, of unginned cotton, of petroleum products as a 
whole. If the price of beef, added to the price of hides, is 
more than reasonable compensation for the cost of raising 
cattle, the business of cattle-raising tends to expand. And 
so with other cases of joint products. 

The same principle is very clearly illustrated in the busi- 
ness of transportation. A ship or a railway train may 
carry passengers of different classes, as well as a wide 
variety of baggage and freight. How much does it cost a 
railway company to carry a particular passenger from 
Chicago to New York? From one point of view the cost 
appears to be almost nothing. The train would run even 
if this passenger remained in Chicago. An empty seat 
would be hauled from city to city, instead of an occupied 
one. The passenger adds his weight to the load that the 
engine must draw, but a few cents would easily cover this 
cost. What is true of one passenger is true of any other ; 
he could be carried for nothing, if the costs entailed by his 
presence were alone considered. The cost of running the 
train, however, is a very large sum, and this is the immedi- 
ate cost of carrying the passengers as a body. 

But the cost of running trains is not the whole cost of 
the service of the railway company. The track must be 
kept in repair ; interest must be paid, on capital invested in 
roadbed, terminals, etc. How much of this cost is assign- 
able to the passenger service, how much to the freight 
service ? It is impossible to say. The entire service of the 
railway has an ascertainable cost and a normal price ; each 
separate service has not. 

12. The cost of production varies from establishment to 
establishment. At any given time normal price is deter- 
mined by the costs of those who produce under the greatest 
disadvantages, or the marginal producers. 

Where the cost of a particular commodity is ascertain- 



56 INTRODUCTION TO ECONOMICS 

able, and any one is free to enter upon its production, the 
price constantly tends toward the level of cost. Cost, then, 
may be said to determine normal value. It is, however, to 
be borne in mind that cost itself is something variable and 
fluctuating. Cost of production in any industry is greater 
for some producers than for others. A given grade of cot- 
ton goods may be produced either in Rhode Island or in 
North Carolina. It may cost an average of ten cents a 
yard in Rhode Island, and nine cents a yard in North 
Carolina. Some Rhode Island factories are better than 
others ; perhaps the cost of producing the cloth is eight 
cents in the best factories and twelve cents in the worst 
equipped ones. And similar gradations may exist in North 
Carolina. So when we say that normal price is fixed by 
cost of production, exactly what do we mean? Average 
cost ? Greatest cost ? Least cost ? 

It may be supposed that a factory which produces at a 
cost of eight cents will run on full time, and with full work- 
ing force, if the price is 8^ cents. If the price is ten or 
twelve cents, it can do no more, unless it can be expanded 
by the erection of an annex. Let us suppose that it would 
take a year to construct such an annex and get it into work- 
ing order. In the meantime the factory produces as much as 
it can when the price rises ; but so it would have done if the 
price had not risen. So far as this factory is concerned, 
the rise in price does not immediately create an expansion 
of supply that reacts upon the price. This factory, then, 
cannot be said to be in a position to control prices. 

But let us suppose that there are other factories which 
produce at a cost of nine, ten, eleven, twelve cents a yard. 
So long as the price remains at 8J cents, none of these, we 
may assume, will be in operation. As soon as the price 
rises to nine cents, the factories producing at that cost will 
open their doors, and by increasing the supply of goods, 
will tend to check further rise in prices. If prices rise 



NORMAL COMPETITIVE PRICE 57 

nevertheless, the factories producing at a cost of ten cents 
will begin operations, and will exert their influence on 
supply and on price. When the price rises to twelve cents, 
it will be the factories producing at this cost that will tend 
to check a further rise in price. When the price is twelve 
cents, the costs of production of the better equipped mills 
— those producing at eight and one half, nine, ten, and 
eleven cents — have little to do with the determining of 
price. If the price rose a little higher, or fell a little lower, 
these factories would continue to produce exactly as much 
as they do when the price remains at twelve cents. They 
do not, therefore, regulate the supply. This the twelve- 
cent mills do, since, if the price falls, they are ready to drop 
out, and reduce supply. 

It is not to be understood, however, that a manufacturer can 
say: "I produce at a cost of twelve cents; I must have at 
least that price," and so force the price up to twelve cents. 
If the market demands that manufacturer's contribution to 
the supply, it must pay twelve cents for every part of the 
supply. The manufacturer in the least favorable position 
cannot fix the price at his cost. He can only withhold what 
he might have supplied, and so bring to bear upon the 
market some small pressure, making for higher prices. 

It is only in a restricted sense, then, that we can say 
that normal prices are fixed by cost of production. Those 
who produce at a cost of twelve cents, by their action in 
placing a product on the market or withholding it, make 
an attempt at holding the price at that point. Perhaps the 
task is too great for them ; the price slips away ; and those 
producing at a cost of eleven cents make an endeavor, by 
the same means, to hold prices at their cost level. They 
also may be unequal to the task, but at last the price rests 
in the hands of producers who are just able to hold it at 
their costs. We may think of these as being on the fringe 
or "margin" of production; they are often called, in 
economics, the marginal producers. 



58 INTRODUCTION TO ECONOMICS 

13. In the long run competitive prices tend toward the level 
of cost of the most efficient producers. 

The price does not, however, rest permanently with the 
same marginal producers. Those producers whose costs 
are less than the price are continually reaping profits ; they 
invest them in new mills, equally well equipped, and bor- 
row capital further to increase their productive capacity. 
In time they greatly increase their output, and this tends 
to reduce the price of the commodity. The marginal pro- 
ducers find the burden of holding the price at their cost 
level growing heavier and heavier; soon the price breaks 
away from them altogether, and is held for a time at the 
cost level of slightly more efficient producers. But the 
most efficient producers continue to enlarge their works ; 
an increasing supply is thrown upon the market, and the 
price settles to a still lower level, where it equals cost to 
producers who formerly enjoyed a slight profit. In this 
way prices are continually gravitating toward the level of 
cost of the most efficient producers. 

It may therefore be said that for a short period price is 
determined by the costs of production of those who produce 
at the greatest expense, but whose contribution to the 
supply is necessary in order that the existing demand 
may be met. In the progress of time, however, such pro- 
ducers are unable to hold prices at their cost level, and are 
forced out of business. The final adjustment — if it should 
ever be attained — would leave price at the level of cost to 
the most efficient producers, all of whom would stand on a 
plane of equality as to costs. 

This does not mean, however, that the price of a given 
commodity must continue to decrease. The cost itself 
may increase, for the more efficient as well as for the less 
efficient producers. As we have used the term, cost in- 
cludes the value of raw materials and fuel; interest on 
capital, whether fixed in land, buildings, and machinery, or 



NORMAL COMPETITIVE PRICE 59 

invested in raw materials, etc.; wages of all labor employed; 
and a number of lesser items — taxes, insurance premiums, 
etc. Now, every one of these elements in cost is perpetu- 
ally fluctuating in magnitude according to its own peculiar 
laws. The sources of raw material may be "approaching 
exhaustion ; wages and interest may be rising ; taxes may 
be growing heavier. But while such an increase in costs 
may prevent the more efficient factory from producing as 
cheaply as before, it burdens the less efficient proportion- 
ately. It cannot, then, prevent prices from tending toward 
costs to the most efficient producer. 

14. Summary. 

The market prices of commodities are subject to con- 
tinual fluctuations. These fluctuations are greatest in the 
case of commodities that rapidly deteriorate and that are 
dependent upon a local market. Despite such fluctuations 
there is a discernible tendency toward a normal level of 
prices. This level is determined by the cost of production. 
The force that causes market prices to hover about cost of 
production is competition between the several producers. 

The ease or difficulty with which supply may be in- 
creased or diminished determines the degree of possible 
deviation of prices from the normal level. Marked devia- 
tions are frequent in the case of agricultural products, 
since unforeseen seasonal influences are constantly vitiating 
the calculations of the producers. Great deviations are 
possible where production is governed by calculations 
looking to the remote future. 

The costs of production in every industry vary consider- 
ably from establishment to establishment. In short periods 
of time the costs of those establishments which labor under 
the greatest disadvantage play a chief part in determining 
prices. In the long run prices tend toward the level of 
cost of those establishments which enjoy the greatest 
advantages in production. 



CHAPTER IV 
MONOPOLY PRICE 

1. The price of a commodity may be controlled by dealers 
or producers through control of supply. 

As has been shown in the preceding chapter, the mechan- 
ism which keeps prices hovering about cost of production 
consists in the automatic adjustment of supply to demand. 
If price rises, supply increases, and thus price is forced 
down again. If then the supply of a commodity can be 
controlled by the producers, the price is, in some measure, 
also within their control. With this control, the producers 
are in the happy situation where they can, within limits, en- 
rich themselves at their pleasure. It is no wonder, then, 
that producers and dealers from very early times have 
sought to bring supply under control. Joseph controlled 
the total supply of grain in Egypt, we are told ; he was 
thereby enabled to charge whatever prices he pleased, and 
the prices he fixed were such that he got in exchange for 
his grain all the possessions that the Egyptians had. In 
ancient and mediaeval times, when roads were bad and the 
costs of carriage prohibitive, whoever should buy 'up the 
stock of grain in a town would make himself practically 
master of the town. He could measure out the grain in 
small quantities, charging whatever prices seemed good to 
him. 

To-day, as in earlier times, business men are constantly 
seeking to gain control over the prices of the commodities 
in which they deal. That some are at least partially suc- 
cessful in this is shown by the great number of articles the 
prices of which do not vary. Price control extends, how- 
ever, far beyond the field of constant prices. A man who 

60 



MONOPOLY PRICE 61 

has absolute control over the sale of a commodity may be 
expected to fix high prices in times of prosperity, low prices 
in times of depression, and in many cases this policy ap- 
pears to be followed by those men who now have practical 
control of the prices of the commodities which they sell. 

2. Power to control prices is commonly termed monopoly. 

In the strictest sense of the term, monopoly is the exclu- 
sive privilege of selling a commodity or a service. Most 
governments have a monopoly, in this sense, of the postal 
service. Some governments monopolize the sale of to- 
bacco; others, the sale of salt; still others, the sale of 
spirituous liquors. The exclusive privilege of sale is some- 
times granted by government to private individuals or cor- 
porations. A common example of this kind of monopoly 
is the patent by which an inventor is assured control over 
the use of his invention, or the copyright by which an 
author is given control over the sale of his book. In many 
cases a private corporation is given the exclusive right to 
supply a city with water, gas, or electric light. In some 
cities only one street railway company is chartered, and 
in some countries steam railway companies are given 
monopolies of the transportation service within specified 
areas. Monopolies created by law, then, are both numer- 
ous and important. In a democratic state they are not 
likely to grow into a serious abuse ; in a state where the 
government is not really controlled by the people, such 
monopolies may become exceedingly oppressive. 

3. A partial monopoly can be established by private 
persons, through agreements fixing prices or limiting supply. 

Let us suppose that the producers of a given com- 
modity agree among themselves not to sell below a 
certain price, or, what leads to the same result, not to 
produce more than an amount so small as to com- 
mand scarcity prices. If producers are few — say half a 
dozen — such an agreement may stand. No one can 



62 INTRODUCTION TO ECONOMICS 

materially increase his sales without attracting attention; 
moreover, no one can increase his sales without an immedi- 
ate effect on price. If the producers number millions, 
such an agreement is empty words; almost any one can 
violate it without detection, and without any appreciable 
effect on price. And the number of violators of the agree- 
ment will be so great that no control of supply or of 
price can be exercised. 

When the number of producers is small, then, there 
may be effective control of supply. But such control 
cannot long be retained unless new producers can be 
kept out of the field. 

The producers of cotton yarn of the higher grades are 
not very numerous. It is therefore conceivable that they 
might agree to limit supply and force the price to a point 
paying a " fair " profit. But it is not a difficult matter 
to build and equip a mill to produce a given grade of 
cotton yarn. If, then, the price were forced to a high 
level, new producers would soon appear. These would 
enjoy the benefit of the high price, although to effect sales 
they would have to cut prices slightly. The original 
producers would have to reduce their prices ; the new pro- 
ducers would then cut still lower, and so on until the 
price had reached cost of production. Indeed, the price 
would almost certainly go lower than this, for the number 
of producers, each striving to get more customers, would 
have increased. The last state of the cotton yarn business, 
accordingly, would be far worse than its first. We have 
had in America not a few examples of attempted monopo- 
lies which in the end merely intensified competition. 

4. Permanent price control may be secured through con- 
trol over some element essential to production, such as labor, 
raw material, means of transportation. 

If the industry which it is sought to monopolize requires 
a very high grade of skilled labor, and the members of 



MONOPOLY PRICE 63 

the combination control the whole supply of labor of this 
grade, the monopoly may rest secure until new labor 
can be trained for the shops of would-be competitors. 
If the only satisfactory way of training such labor is 
through apprenticeship under men already working in 
the trade, it becomes difficult indeed for a competitor to 
get an independent supply of labor. This situation might 
become a serious one in some industries were it not for 
the fact that it is not easy for one set of employers 
permanently to control their workmen. The latter know 
that at any time they can thwart their employers' mo- 
nopolistic schemes by accepting employment with com- 
petitors; and this knowledge is made good use of, in 
forcing constantly higher wages. Where monopolies of 
this kind have arisen, they have generally been broken 
up on account of disputes between the employers and 
their workmen. 

Some products depend upon supplies of raw material 
that are found in comparatively few parts of the earth, 
and in limited quantity. If a combination of producers 
can get possession of all or most of the mining or agricul- 
tural lands which are capable of yielding a certain product, 
they may win their desired freedom from the danger of 
new competitors. Anthracite coal, for example, is found 
only in a restricted area in the United States. A combi- 
nation of capitalists of very great wealth might with 
comparative ease control the total output — and indeed, 
something of the kind now exists. Such a combination 
has nothing to fear from new competitors, although of 
course it must meet the competition of producers of other 
fuels. 

In the history of the American petroleum industry, 
there was a time when the Standard Oil Company, through 
ownership of pipe lines, enjoyed an immense advantage 
over its competitors, who were compelled to ship petroleum 



64 INTRODUCTION TO ECONOMICS 

over the railways. The Standard Oil Company was not, 
indeed, enabled by this advantage to destroy competition 
entirely; its control over supply was, however, notably 
strengthened by the ownership of the pipe lines. 

5. Permanent price control is sometimes maintained 
through the systematic intimidation of competitors. 

Let us suppose that there is a combination of the more 
important producers of coal, who yet have nothing like 
complete ownership of the coal lands, and that there are 
a number of small competitors whose natural market is a 
city.which we will call X. Other markets, we will assume, 
are so far distant that cost of transportation prohibits their 
supply from the mines of the small producers. The com- 
bine, let us say, has mines from which it can supply the 
market X, as well as a great number of mines supplying 
other cities. If, then, it desires to destroy the business of 
its small competitors, it may decide, for a while, to sell coal 
in X for less than the cost of raising it from the pit. This 
the combination can afford to do, because it is enjoying 
high profits from its monopolistic position in the supplying 
of other markets. Of course the small competitors can sell 
no coal at prices which will meet those of the combine ; 
very soon they become discouraged and retire from busi- 
ness. Then the combine can raise prices of coal in X to 
a profit-yielding point. The small producers will probably 
not again attempt to compete, knowing that the same tactics 
will again be employed to destroy their business. 

Of course, if coal were easy to transport, this method 
would prove very expensive to the monopolistic combina- 
tion. An enterprising dealer in the town X, finding that 
the combination sold coal there at much lower prices than 
in town Y, might buy up coal in the former place and ship 
it to the latter. On every ton of coal sold in X, we have 
assumed, the combination is losing money ; and every ton 
sold in Y helps to depress the price there, to the further 



MONOPOLY PRICE 65 

disadvantage of the combine. In a sense, it would be 
underselling itself. 

Accordingly, some other method of destroying competi- 
tors must be employed when the commodities which it is 
sought to monopolize are of little weight and bulk, as com- 
pared with their value, and hence easily transported. Sup- 
pose that a monopolistic combination controls most of the 
manufacture of cigars, and that an overbold outsider, anx- 
ious to share the benefits of high prices, enters the field. 
He may place on the market an excellent brand of cigars, 
charging for them less than the combine charges for similar 
ones. The combine cannot lower the prices of all cigars 
in the competitor's vicinity, for in that case dealers will buy 
them up and express them to all parts of the country ; and 
thus the combine will be inflicting losses upon itself. But 
there is another method which it may find efficacious. 

Let us say that the independent producer calls his brand 
of cigars the " Rex." It is his all ; his fortune is bound up 
with its fate. The combine has 500 brands; it makes 
profits on all of them. Accordingly, it can afford to put 
out a new brand of cigars — say the " Regina " — for half 
the price of the Rex, though of as good quality, and place 
it on the market wherever the Rex is sold. Before long 
the Rex is no longer purchased ; its producer goes out of 
business. Then the combine puts worse tobacco into the 
Regina, until at last, like all its other products, this cigar 
is dear at the price. 

6. Monopolies that are not based upon privileges granted 
by government are rarely complete, and consequently are 
influenced in the fixing of prices by fear of competition. 

To destroy a competitor is a proceeding that almost 
always involves heavy expense. If a powerful combina- 
tion desires to destroy a small but vigorous competitor, it 
is often obliged to sell below cost, not only to those per- 
sons who actually deal with the competitor, but also to 



66 INTRODUCTION TO ECONOMICS 

many other persons in the same market. The combination 
can compel its competitor to lose money, but in so doing it 
loses money itself — sometimes ten dollars for every dollar 
its competitor loses. Accordingly, it is often cheaper for 
a combination to buy up the plant of a competitor, even at 
an unreasonably high price, than to force the plant to close 
down through price-cutting. If the competitor refuses to 
sell to the combination, the latter may adopt a " live and 
let live " policy, agreeing to respect the competitor's right 
to his territory and established trade, so long as he does 
not appear obnoxiously active in increasing his business. 
All the great American trusts have competitors toward 
whom they observe a policy of toleration. The trust sets 
a price upon its products, and the independent concern 
sells at the same price. If, however, this price is so high 
as to offer great profits, the independent concerns grow 
stronger and stronger, and in the end extend their business, 
encroaching upon the field of the monopoly. 

It is not alone the competition of the existing independ- 
ent concerns that a monopoly has to fear. Very high 
prices are likely to induce new competitors to enter the 
field. Such competitors must either be driven from the 
field by the expensive policy of price-cutting, or some of 
the business of the monopoly must be surrendered to them. 
In fixing prices, then, the monopolist must have regard not 
only for actual competition, but also for such competition 
as might arise, ox potential competition. 

7. A complete monopoly will fix prices at a level that 
yields the maximum return above all costs. 

Suppose that a monopoly has complete control of the 
salt that is to be sold in the United States. It may cost 
one cent a pound to produce it. At what price will the 
monopoly sell it? If the price is one cent, perhaps one 
billion pounds can be sold. If the price were raised to 
two cents, who would eat his food unsalted? Who would 



MONOPOLY PRICE 67 

economize salt in the least? It is safe to say that there 
are few persons in the United States so poor that they 
would not go on eating as much salt as before. And the 
same thing would be true if the price were raised to five 
cents a pound — a price of which four fifths would be 
monopoly profit. 

But not all the salt is for table use ; a large part of the 
total supply is used for live stock and for manufacturing 
purposes. If the price of salt rises, the use of it for these 
purposes declines. When salt is very cheap many farmers 
scatter it on the ground for their cattle, or leave it in 
troughs with no shelter, where the weather devours more 
of it than do the cattle. High price would mean econ- 
omy. So, at two cents a pound, probably not more than 
900,000,000 pounds will be used, instead of 1,000,000,000. 
At five cents a pound the amount taken might shrink to 
800,000,000 pounds ; at ten cents, to 700,000,000 ; at 
twenty, to 500,000,000. Were the price forced up to $1 a 
pound, very likely great economy would be exercised even 
in the use of salt in human food. Perhaps not more than 
80,000,000 pounds would be used. 

Now, while the monopoly would make the enormous 
profit of ninety-nine cents a pound at the last-mentioned 
price, this would be a very irrational price for it to set. 
The total profit from the sale of salt would, according to 
our assumed volume of sales, be $79,200,000. And this 
would be much better than selling 1,000,000,000 pounds at 
cost, or 900,000,000 at two cents. The latter price would 
yield just $9,000,000 profit. At five cents the monopoly 
would get a profit of $32,000,000; at ten cents, of 
$63,000,000; at twenty cents, of $95,000,000. So twenty 
cents is really a more profitable price for the monopoly 
than $1. At twenty-five cents, however, 400,000,000 
pounds might be taken ; and this would mean a profit 
aggregating $96,000,000. This, then, is a still better price 



68 INTRODUCTION TO ECONOMICS 

than twenty cents, from the monopolists' point of view. 
Let us suppose that at thirty cents 300,000,000 pounds 
will be taken. The profit at this price would amount to 
only $87,000,000. This price, accordingly, is too high ; 
and the best price for the monopolist lies between twenty- 
five and thirty cents. 

Of course this would be an exorbitant price; and far 
more extortionate than any existing monopoly price. But 
given the conditions — a complete monopoly of salt — ex- 
tortionate prices can be established. One must have salt ; 
he must have a certain amount of it. There is nothing in 
the world that can be substituted for it. And even if the 
price were exorbitant, the cost of salt would form no very 
large item in any one's expenditure. No one would leave 
the country to escape the monopoly. 

8. The greater the elasticity of demand for commodities 
controlled by monopolies, the lower will be the price that 
yields the maximum monopoly profit. 

The demand for salt is peculiarly inelastic. To do 
without salt altogether is impossible ; to reduce consump- 
tion always involves hardship. Most other commodities 
can be replaced by substitutes. One kind of food readily 
takes the place of another; cottons may be replaced by 
woolens, linens, and silks ; wood for building purposes may 
give way, in large degree, to stone, brick, and concrete. 
There is almost always an ill-defined boundary between 
the consumption of one commodity and that of another, 
and changes in relative prices shift the boundary now in 
one direction, now in another. 

Let us suppose that a monopoly has gained control of 
the entire supply of beef in the United States. Perhaps 
the cost price at which beef can be placed on the market 
is ten cents a pound. With beef at this price, the Ameri- 
can people might conceivably eat 100 pounds per capita — 
8,000,000,000 pounds in round numbers. At eleven cents, 



MONOPOLY PRICE 69 

some of the poorest people would cease eating beef and 
use mutton or pork instead, or use less meat of any 
kind. Perhaps the amount consumed would fall to 
7,000,000,000 pounds. That would give the beef mo- 
nopoly a princely income — $70,000,000. At twelve cents 
the amount consumed might fall to 6,000,000,000 pounds ; 
but this would yield a net profit of $120,000,000; and if 
the amount at thirteen cents fell to 5,000,000,000 pounds, 
the profit would yet amount to $150,000,000. Fourteen 
cents and 4,000,000,000 pounds would be still better for 
the monopoly — $160,000,000. But fifteen cents and 
3,000,000,000 pounds would be a step backward, for the 
profit would be only $150,000,000. Fourteen cents, then, 
is the most that the monopoly could wisely charge. 

Of course, if the demand does not shrink so rapidly as I 
have assumed, the maximum price can safely be placed 
at a higher figure. If the shrinkage is more rapid than I 
have assumed, fourteen cents is too high. 

As the number of commodities offered to the public for 
consumption is continually increasing, it is safe to say that 
the average consumer grows less and less dependent upon 
any one. Demand, accordingly, grows constantly more 
elastic, and the power of monopolies to fix prices at a high 
level constantly diminishes. 

9. In fixing prices , a monopoly is more or less extortionate 
according as it pays less or more attention to the ulterior 
effects of high prices. 

If it is the intention of the monopolist simply to exploit 
the beef market for one year, — to corner the present sup- 
ply, make the most out of it, and then retire to live on his 
plunder, — he may find that at fourteen cents there will be 
no greater shrinkage of demand than has been assumed in 
the foregoing example, and this will then be the best price 
for him to set. Most persons who are accustomed to this 
article of diet will continue to buy it even at the higher 



70 INTRODUCTION TO ECONOMICS 

price. But in a year more and more of them will form 
other habits. A corner in beef organized in the following 
year might not be able to charge more than twelve cents 
without diminishing total net profit ; and in the third year 
a corner might not be able to charge more than eleven 
cents. Accordingly, a monopolist who does not mean to 
retire from business must generally avoid charging a price 
that would give the highest possible returns for one year. 
He must fix prices in such a way as to keep the bulk of his 
custom from year to year. And this is one reason why 
modern monopolists are less extortionate than the ancient 
and mediaeval " engrossers " of the necessaries of life. 
As a rule, the modern monopolist hopes for steadily in- 
creasing profits from a growing business; he therefore 
cultivates his clientele through prices that are moderate. 

If a ring of speculators of immense wealth should buy up 
the entire American cotton crop, they could fix the price 
of cotton at twice the normal price, and yet sell most of it. 
Cotton fabrics would advance in price, but not proportion- 
ately, for many persons would go without cotton cloth 
rather than pay unreasonably high prices. The profits of 
cotton manufacturers would fall ; wages of cotton opera- 
tives would be reduced. The cotton manufacture would 
decline ; many cotton operatives would go into other em- 
ployments. Cotton production in Egypt, India, and Aus- 
tralia would be stimulated. It would take more than a 
year, however, for such adjustments to take place. In the 
meantime the speculators would have sold their cotton 
at high prices, and reaped their extortionate profits. The 
injury occasioned by the changes in cotton manufacture 
would fall upon the producers of the succeeding American 
cotton crops. 

If a combination of capitalists were to secure possession 
of the entire business of petroleum refining, it would be no 
less easy for them to obtain exorbitant profits for one year. 



MONOPOLY PRICE 71 

But the decline in consumption that would follow, when 
time had been given the people to provide themselves with 
other sources of light and power, would seriously impair 
the future profits of the petroleum monopoly. Now, no 
profit, however exorbitant, on a single year's sales, is to be 
compared with comfortably high profits for an indefinite 
series of years. Great fortunes are to be obtained through 
the permanent monopolization of the means of producing 
a commodity, rather than through cornering the visible 
supply and exacting excessive prices, without regard to the 
effect of the policy on future sales. For this reason mo- 
nopolies of the permanent kind are continually increasing 
in number and importance, while it is only rarely that a 
temporary monopoly is successfully carried through. 

10. In order to secure the maximum profit, a monopolist 
often endeavors to classify consumers, and to burden each 
class according to its ability to pay high prices. 

There are some classes of consumers who will pay in- 
creased prices without a murmur, while other classes will 
not only feel greatly aggrieved, but will even refuse to buy, 
when prices are appreciably increased. To the rich it 
makes little difference whether beef is high or low. If the 
monopoly can array its customers in groups, according to 
their readiness to pay high prices, it can grade its prices 
accordingly. The classes that will endure only a slight 
increase in price are given prices so moderate that they 
continue to buy, while the classes that are less apt to com- 
plain over an increase are forced to pay prices that yield 
a higher profit. This is much better for the monopoly 
than to fix an average price which drives away the former 
classes, and does not exploit the latter to the highest 
possible degree. 

How, then, can a monopoly make such a division of its 
customers into classes according to their profit-yielding ca- 
pacity ? One way consists in different prices for different 



72 INTRODUCTION TO ECONOMICS 

localities. If there is greater per capita wealth in Cali- 
fornia than in North Dakota, a monopoly would charge 
higher prices in the former than in the latter state, even 
allowing for all costs of transportation. Suppose that the 
cost of production of beef for North Dakota is ten cents, 
and the cost of transportation practically nothing ; the cost 
of production of beef for California we may assume is the 
same, and the cost of shipping two cents a pound. The 
beef may be sold in Dakota for eleven cents and for fifteen 
in California — giving a net profit of one cent in the for- 
mer state and three in the latter. Of course, the difference 
could be as great as this only in case shipping beef in small 
quantities is expensive; otherwise outsiders would buy 
beef in Dakota at eleven cents, ship it to California, and 
make a good profit. And here we have one limitation upon 
a monopoly's power to vary its charges for different locali- 
ties. The difference cannot permanently remain at a figure 
which is greater than the sum an outsider would have to 
pay in transporting the monopoly's goods from the point 
where they are cheap to the point where they are dear. 

In the case of many goods, however, different qualities 
are sold to different classes of consumers. The choicest 
cuts of meat go to one set of consumers, and the remain- 
ing cuts, in order of toughness, to the various sets of con- 
sumers who have less to spend. Now the consumers of 
the cheapest beef may stand a slight increase in price 
before substituting something else for beef ; while those 
who consume the best quality may see the price double 
before substituting even a cheaper grade. The far-sighted 
monopolist, then, instead of increasing the prices of all 
grades uniformly, will so distribute the increase of price as 
to burden each class of customers as much as they will 
bear without withdrawing custom. 

In some cases where no real differences in quality exist, 
the consumer is made to believe that there are such differ- 



MONOPOLY PRICE 73 

ences. Some years ago — and perhaps to-day — there were 
several grades of salt on the market, selling at different 
prices. The manufacturer who produced them has ad- 
mitted that they were all exactly the same. The classes 
who could afford to pay high prices for salt bought the 
grade that was alleged to be the best; those who could 
pay less bought cheaper grades. Thus the manufacturer, 
who enjoyed a limited monopoly, was able to make each 
class of consumers pay according to ability. It is easy to 
see how far this principle might be carried in the case of 
such articles as soap, chocolate, canned goods. It is a 
wise man who knows what ingredients go into these com- 
modities ; and if the manufacturer, who must know, says 
that one is purer and more choice than another, what can 
you or I do but accept his statement and pay the higher 
price for the so-called better quality ? 

11. A monopoly may maintain prices at a higher level in 
the domestic market than in foreign markets. 

A few years ago a New York dealer offered for sale 
a considerable stock of watches of a standard American 
make at prices far lower than are commonly charged by 
the manufacturer in the same city. These watches had 
been purchased in England at such low prices that the 
dealer was able to make a handsome profit in bringing 
them back to America and selling them at cut prices. It 
is well known that American agricultural machinery is 
often sold more cheaply in foreign countries than at home, 
in spite of the cost of shipping. The German steel com- 
bination sells steel to the British consumer more cheaply 
than to the German consumer, and the American steel 
trust is frequently charged with a similar discrimination 
in favor of foreign purchasers. The principle is a fairly 
common one ; it is probable that of the American monopo- 
lies that have invaded foreign markets there are few that 
have not in some degree employed this principle. 



74 INTRODUCTION TO ECONOMICS 

Such discriminations are to be explained by the fact that 
for one reason or another the domestic consumer can be 
made to pay higher prices than the foreign consumer will 
tolerate. In some cases the American consumer can be 
made to pay higher prices simply because he is more 
addicted to careless expenditure. This explains price dis- 
criminations in the case of such articles as watches, razors, 
pipes, etc. In other cases the foreign consumer is favored 
because he can avail himself of the competition of foreign 
producers, who are excluded from the American market 
by our customs duties. This explains price discriminations 
in such products as steel rails. In yet other cases the 
discrimination is explained by the fact that the foreign 
consumer has access to a greater number of substitutes 
than the domestic consumer. 

12. In railway transportation, the principle of discrimi- 
natory charges is very widely employed under the name of 
"charging what the traffic will bear" 

Almost every railway is, in a limited sense, a monopoly. 
It may encounter competition at important business cen- 
ters, but most small cities and towns are absolutely de- 
pendent upon a single line. Leaving out of account 
public regulation of railway rates, we may say that the 
railway will burden each class of shippers according to 
the ability of that class to pay. The shippers of silks 
can be made to pay a high rate per ton mile; the ship- 
pers of bricks must have a low rate, or it will be impos- 
sible for them to remain in business at all. If allowed to 
pursue its own devices in rate making, the railway would 
naturally discriminate between the different producers of 
the same commodity. The owner of a well-situated mill 
would be forced to pay a higher rate than the owner of 
a mill badly situated. The owner of a rich farm would be 
made to pay a higher rate than the owner of a poor farm. 
The shipper who is in a position to avail himself of the 



MONOPOLY PRICE 75 

competition of a rival line would receive better rates than 
the shipper who can use one line only. The last form of 
discrimination has been exceedingly common ; it is not yet 
extinct, though under the ban of the law. 

13. Monopolies must endeavor to preserve their customers' 
prosperity, and to assist them in meeting competition. 

In spite of the fact that railways hold a monopoly po- 
sition, and avail themselves of the principle of discrimi- 
natory charges, it is very seldom that a railway secures 
excessive profits. This is because the demand for railway 
service is extremely elastic. A high general level of rates 
" kills business." The fruit of Southern California must be 
carried to the Eastern market over a single line of railway. 
But that railway cannot raise rates on fruit to a very high 
level without destroying the business of fruit culture in 
California. Though the railway itself has no competitor, 
the fruit growers are engaged in an active competition with 
those of Florida and the West Indies, and the railway must 
make it possible for its customers to hold their own. 

In like manner, a monopoly of anthracite coal must sell 
this fuel at a price so low that manufacturers using an- 
thracite are not seriously handicapped in their competition 
with manufacturers in other parts of the country who use 
bituminous coal. A monopoly of tin cans would have to 
fix prices at a level low enough to permit the industry of 
preserving fruit to hold its ground against the business of 
drying fruit. The lumber dealers of a town may have an 
inviolable agreement fixing prices, but they will not place 
prices so high as to handicap the town in its competition 
for population and business. Monopoly prices, therefore, 
are not likely to be ruthlessly exorbitant. They are usu- 
ally not higher than the customers of the monopolies can 
pay without serious impairment of their power of survival. 
None the less they are higher than they should be, and 
enable those who hold a monopoly position to draw to 



76 INTRODUCTION TO ECONOMICS 

themselves a larger share of the social income than their 
services justify. 

14. Summary. 

Monopoly is attained through the control of the supply 
of a commodity or a service. This control may be secured 
through governmental restrictions or through private agree- 
ments fixing prices or limiting output. Monopolies resting 
merely upon the agreements of independent producers are 
inherently weak. 

If some essential element in the production of a good can 
be controlled by a single enterpriser or by a group of enter- 
prisers who are able to work in complete harmony, a well- 
nigh impregnable monopoly may be established. A high 
degree of monopolistic control is often attained through in- 
timidation of competitors. Monopolies are seldom entirely 
free from competitors, and hence are compelled to fix prices 
at a level which offers slight inducement to competition. 

A complete monopoly will fix prices with a view to se- 
curing the greatest aggregate return from the entire busi- 
ness. The more elastic the demand for a commodity, the 
lower will be the price which affords the maximum net return. 
When it is the aim of a monopoly to hold permanent con- 
trol of the supply of a commodity, it is necessary to fix 
prices at comparatively low level, in order to prevent the 
demand from dwindling away in the course of time. 

In order to gain the greatest monopoly return with the 
least shrinkage of custom, it is often advisable for the 
monopolist to discriminate in prices, burdening heavily 
those who can be made to pay high prices, while levying 
moderate charges upon those who cannot pay high prices. 
In railway transportation, this practice is commonly de- 
scribed under the name of "charging what the traffic will 
bear." No enlightened monopoly will charge prices so high 
as to handicap its customers in their competition with per- 
sons not subject to the control of the monopoly. 



CHAPTER V 

THE COST OF PRODUCTION 

1. A complete explanation of prices involves a statement 
of the laws governing the costs of production. 

The preceding chapters have shown that the costs of 
production play an exceedingly important part in deter- 
mining the values of goods. Commodities produced under 
competitive conditions tend to sell at cost; commodities 
the production of which is controlled by monopolies sell 
above cost, as a rule, but at prices which usually stand in 
a close relation to the costs of production. In practical 
life, one rarely carries the analysis of value further than 
this. Costs appear to the individual producer as some- 
thing fairly definite and fixed, upon which he may safely 
base his calculations in deciding whether or not he shall 
enter a given line of business. 

From a business point of view the cost of producing a 
commodity or a service consists in the aggregate price of 
the commodities and services used up in the process of 
production. The greater part of the cost of most com- 
modities is made up of the price of materials, the price of 
labor, and the price of the use of the capital invested in 
plant. These prices the individual producer must, as a 
rule, accept as he finds them, just as he accepts the price 
of finished products as he finds it. We have seen that by 
increasing or reducing the volume of his production, the 
individual business man exerts a real, though imperceptible, 
influence upon the price of finished products. It is obvious, 
at the outset, that the individual business man must exert 
a like influence on the price of the commodities and serv- 
ices that enter into his production. If he extends his 
business, he must increase his demand for labor, machin- 

77 



78 INTRODUCTION TO ECONOMICS 

ery, and materials, and this cannot fail to affect the prices 
of these factors. 

2. The materials of production have market and normal 
prices governed by the same laws as the prices of finished 
products. 

We may examine briefly the process by which cotton 
yarn, the material of the cotton-weaving industry, is valued. 
A multitude of weavers desire to buy it; some of them 
would pay a price of \ox per hundred pounds rather than 
go without it; others would pay only $x per hundred 
pounds. A multitude of sellers stand ready to furnish 
cotton yarn ; some may be willing to sell at 5 x rather 
than not sell at all ; others may be willing to sell only if 
the price is \ox. What price will actually be set? Just 
as in the case of commodities for direct use, the market 
price is fixed at a point where demand and supply are 
equal — that is, where the amount offered at a given price 
is exactly equal to the amount that will be taken at that 
price. 

But the price fixed at any moment by demand and sup- 
ply may exceed the cost of producing the yarn, even in the 
mills of those enterprisers who produce at the greatest cost. 
In such case the output of cotton yarn increases, and the 
price falls until it just covers cost of production to those 
who are producing at the greatest disadvantage. If the 
price were to fall still lower, these producers would have 
to quit the business; and this would reduce supply and 
thus of itself tend to force up the price of cotton yarn. 
But the same price may be high enough to give excellent 
profits to the more efficient producers ; these continue to ex- 
tend their business, and the increase in supply from this 
source may be more than an offset for the decrease resulting 
from the closing of the less efficient mills. Thus the price 
gravitates steadily downward, resting momentarily at cost 
of production to the least efficient producers ; then sinking 



THE COST OF PRODUCTION 79 

to the cost level of slightly more efficient producers ; finally 
resting at the level of cost of the most efficient producers 
of all. Thus it appears that we need no new law to explain 
the action of buyers and sellers of cotton yarn. They act 
just as they would if they were buying and selling a com- 
modity ready for consumption. 

3. Fluctuations in the price of a product are reflected, in 
greater or less degree ; in the prices of materials employed in 
making the product. 

If, through a general increase in the demand for cotton 
fabrics, the price of cotton cloth everywhere rises, all the 
manufacturers of cloth at first enjoy a profit. To increase 
that profit each manufacturer tries to extend his business, 
and this tends to bring down the price of cloth. But in 
order to extend the cotton cloth manufacture, more yarn 
must be had. The cloth manufacturers are forced to bid 
against one another for the existing supply of yarn, and the 
price of yarn rises. 

We see, then, that it is not merely because of competi- 
tion in the sale of finished products that such products sell 
at cost; it is also because of competition in the purchase 
of the elements of production. If the price of cloth is for 
a time much above cost, the expansion of the cloth manu- 
facture tends to lower the price of cloth and raise the price 
of yarn and other elements in cost, until the price of cloth 
and its cost are again nearly equal. 

Looking now at the manufacture of yarn, we see that 
such an increase in the price as we have assumed will 
result in high profits throughout the industry, and conse- 
quently will give rise to an attempt on the part of each 
manufacturer of yarn to increase his output. But an ex- 
pansion of the spinning industry involves an increase in 
the demand for raw cotton. Expansion of the spinning 
industry thus tends to raise the price of raw cotton as well 
as to reduce the price of yarn. 



80 INTRODUCTION TO ECONOMICS 

If, on the other hand, the price of cotton fabrics were to 
decline, we should see this decline reflected in the price of 
cotton yarn, and later in the price of raw cotton. High 
prices of finished products thus tend to produce high costs. 
Rise of costs, however, encounters an opposing tendency in 
increased production of the goods that costs represent 

4. The benefits of an increased demand for a finished 
product may rest permanently with the producers of the 
crudest materials that enter into that product. 

If the demand for steel rises, the steel manufacturer 
gains a profit, in the first instance. This benefit is soon 
passed on to the producer of pig iron, in the shape of a 
higher price for that product. An expansion of pig iron 
production follows, and this entails an increased demand 
and a higher price for ore. Thus increased cost deprives 
the pig iron producer of his profit, just as it deprived the 
steel manufacturer of his, profit. The owner of ore mines 
can now demand a higher price for ore, as it is found in 
the mine. This ore has, strictly speaking, no cost; it is a 
free gift of nature. The owner of ore mines, therefore, 
cannot be compelled to surrender his gains to an ante- 
cedent producer. So long as the increased demand for 
steel exists, he enjoys the benefit of high ore prices, 
unless better mines are discovered to compete with him. 

The relation to the price of finished products of the price 
of crude materials, as they exist in nature, is best illustrated 
by examples drawn from primitive conditions, where such 
materials first begin to bear a value. In a newly settled 
country, the cost of bricks would contain no element rep- 
resenting clay in the bank or trees on the hillside. It 
would consist solely in wages of labor employed in cutting 
and hauling the wood, in digging and mixing the clay and 
shaping the bricks, and in interest on capital invested in 
kilns ana drying sheds, etc. Bricks might at a given time 
sell at a price in excess of these costs ; but this would cause 



THE COST OF PRODUCTION 81 

new brickworks to be erected, and the price of bricks would 
fall until bricks were selling at a price merely covering 
cost. 

As population increased, the demand for wood for brick- 
making would increase, as would also the demand for wood 
for other purposes. In time the proprietor of woodlands 
would see an end of the supply within easy distances, 
and would demand a price for wood in the tree. Here, 
then, would be a new element in the cost of bricks. Further 
growth of population might make the supplies of suitable 
clay insufficient to meet all demands, present and prospec- 
tive. The owner of clay deposits could therefore demand 
a royalty for every cubic yard of this material. If the de- 
mand for bricks continued to increase, the price of wood 
and of clay would steadily rise, and thus a constantly in- 
creasing proportion of the selling price of the bricks would 
be absorbed by the cost of the raw material. 

5. The price for the use of land, suitable for one product 
only, fluctuates with changes in the demand for its product. 

In some of the countries of North Europe are found 
extensive tide-marshes noted for the production of exceed- 
ingly nutritious grasses. These lands cannot, without 
great expense, be put to any other use than that of pro- 
ducing forage. When the price of dairy products rises, 
the rental of these lands rises ; when the competition of 
inland districts forces down the price of dairy products, 
the rental declines. Owing to the influence of custom in 
maintaining ground rents at a fairly stationary level, the 
rental of such lands is likely to rise only after the higher 
level of dairy products has been established for a con- 
siderable period. But in time the value of the final prod- 
uct is inevitably reflected in the rental of the land. 

In most cases land may be put to a variety of uses. 
Corn land may be put under grass, fruit, or vegetables. 
The rental of corn land cannot fall below the probable 



82 INTRODUCTION TO ECONOMICS 

rental that the land would yield under other crops. But 
often land is so peculiarly suited, by quality or by situa- 
tion, for the production of a specific crop that the price 
of its use comes to depend upon that one crop alone. 

Let us suppose that a beet sugar manufactory is estab- 
lished somewhere in the heart of the wheat belt. Natu- 
rally, if a farmer wishes to rent a field upon which to grow 
sugar beets, he will have to pay as high a rental as wheat 
growers in the vicinity pay for the same quality of land. 

Beet growers may find, after paying all other costs, that 
a considerable profit remains in their hands from the sale 
of their beets. In such case this form of culture will 
expand, and more and more wheat land will be devoted 
to the growing of beets. The increasing output of beets 
may conceivably reduce their price; but more probably, 
since an enormous increase in the sugar output of a given 
locality is yet a very small addition to the world's sugar 
supply, the price of beets will remain fairly constant. 
Accordingly, the expansion of the industry will continue 
until all the good lands within a reasonable distance from 
the factory are given over to this branch of agriculture. 
If the beet growers still have a surplus profit, they will 
compete among themselves for land, each desiring to in- 
crease his acreage. Higher rents will be offered, until 
the extra profits of the enterpriser are absorbed by this 
increasing element in cost. If for any reason the price 
of sugar rises to a higher level, the rental of beet lands 
must also rise. 

6. Under certain conditions the wages of labor are inti- 
mately connected with the price of a particular product. 

Let us imagine that a new branch of production arises 
— say, the manufacture of wrapping paper from corn- 
stalks. A single factory is erected, and let us assume that 
it will be operated in the winter months only. The fac- 
tory we may suppose is established in the country, near 



THE COST OF PRODUCTION 83 

the source of raw material. And in the country there is a 
great deal of labor that is not employed in the winter 
months. At what rate will our manufacturer be able to 
hire this labor ? 

It is clear that the cost of living will have nothing to do 
with the wages fixed. Country laborers are paid enough 
in the open months of the year to carry them through the 
winter. What they earn in the paper factory is a net addi- 
tion to their annual income. They can work for nothing, 
and be no poorer than they were before the factory was 
erected. The work in the factory may be pleasant rather 
than otherwise. Nevertheless, it is safe to assume that 
some rate of wages must be paid. Perhaps a wage of 
fifty cents a day will provide the requisite amount of labor. 
If so, that is all the manufacturer will pay. 

Now, if the manufacturer gets his labor at such a low 
rate, he may make extraordinarily high profits. In this 
case other enterprisers are likely to go into the business. 
If the industry assumes extensive proportions, it soon 
drains off the supply of labor that can be had for fifty 
cents a day. Further expansion becomes possible only 
through an increase in wages which will tempt into the 
industry workmen who regard their ease as worth more 
than fifty cents a day, or who are earning at least that 
wage in caring for live-stock, etc. But profits may still 
be high, and new enterprisers may be continually enter- 
ing the business. To secure laborers they are compelled 
to offer wages slightly higher than those paid by the 
enterprisers whose business is already established. The 
latter, in order to retain their laborers, are compelled 
to meet the bids of their new competitors. Thus wages 
for this kind of work go up, until all the enterprisers are 
fully supplied with workmen. 

Any further expansion will be followed by a similar in- 
crease in competition among employers of labor, and a rise 



84 INTRODUCTION TO ECONOMICS 

in the rate of wages will be necessary in order to induce 
less industrious workers, or workers having some alterna- 
tive employment, to enter the factories. But each expan- 
sion of the industry means an increased product thrown 
on the market, and, other things equal, a lower price for 
it. What with the rising of wages and the falling price of 
paper, it is clear that the profits of the enterpriser must 
decline. Possibly the expansion will continue until wages 
have risen to $2. All depends upon the amount of paper 
that will be taken at a given price, and the amount of 
labor available. 

7. The price of labor depends not only on the price of the 
finished product, but also on the price of other factors in 
production. 

Let us assume that there is a city which has been 
devoted almost exclusively to the manufacture of iron 
and steel goods. A cotton manufacturer, visiting the city 
— Ironton, let us call it — shrewdly concludes that the 
iron workers must have a number of sisters and daughters 
and other female relatives, who are practically wasting 
their time, and who would be glad to earn a small income 
by cotton spinning and weaving. Accordingly he erects a 
mill at Ironton. Very likely he will get all the labor he 
cares for at twenty-five cents a day, while his competitors, 
in the established centers of the trade, are paying a dollar 
a day for the same grade of labor. In this case the cost 
of producing a given grade of cottons at Ironton may be 
twenty per cent lower than the cost of producing the same 
grade in the older centers, while the selling price must be 
about the same since cottons are easily transported from 
one center to another. Of course this will give the enter- 
priser at Ironton large profits. Before long other enter- 
prisers will begin to inquire why a cotton mill has been set 
up at Ironton ; and finding what advantages that city offers 
in the way of low costs, they too will erect mills there. 



THE COST OF PRODUCTION. 85 

The effect of the appearance of these new manufac- 
turers at Ironton is to increase the demand for cheap 
labor. Possibly there are so many women and girls who 
are ready to work for " pin money " that the new mills can 
be plentifully supplied with labor at the same price that has 
been paid by the enterpriser first in the field. But it can- 
not be a great while before the supply of twenty-five-cent 
labor falls short of the demand ; enterprisers erecting new 
mills will have to offer slightly higher wages to entice 
workers away from the older mills, and these will have 
to raise wages to the rate offered by the newcomers. The 
competition will continue until wages are so high as to 
induce a new set of workers to enter the mills. Costs at 
Ironton may still be abnormally low after wages have 
risen, say, to fifty cents a day. In that case the cotton 
industry at Ironton will go on expanding, until at last 
aggregate costs are as great at Ironton as in the older 
centers of the trade. 

The point that here needs emphasis is that the com- 
petition of different centers equalizes, not wages cost, but 
aggregate costs. Coal may be cheaper at Ironton than in 
other centers of the industry ; mechanics' services in the 
erection of buildings and in the setting up and repair of 
machinery may also be cheaper. In such case cotton 
manufacturers at Ironton are not producing at cost even 
when the wages of textile laborers are as high as in other 
centers. There still remains a margin of profit, which 
leads to expansion of the industry and increased demand 
for labor. Under competition wages at Ironton must 
inevitably rise above the average in other centers. We 
may, therefore, formulate the principle that if competition 
exists among different producing centers, all supplying the 
same markets, wages in an industry in one center will rise 
or fall until, together with other costs of production, they 
equal wages plus other costs of production in the other 



86 INTRODUCTION TO ECONOMICS 

centers where the industry is carried on. To give a 
numerical example : if in city A one hundred yards of 
cotton cloth cost $10, of which $8 consists of cost of 
materials, fuel, interest on capital, etc., and $2 of wages; 
and if in city B, which obtains the same price for cloth at 
the mill, all other costs amount to only $7, wages in B will 
rise, under competition, until labor cost amounts to $3. 

Much attention has been given to the fact that in many 
branches of industry the American producer can meet the 
competition of the foreign producer, although the former 
pays higher wages than the latter. In many cases the 
personal efficiency of the American laborer is so much 
greater than that of the foreign laborer that wages cost, 
per unit of product, is less in this country than in foreign 
countries. Wages cost is thus higher only in appearance, 
not in reality. In other cases the low prices at which 
Americans can afford to sell are to be explained by the 
exceptionally low prices prevailing here for other cost 
factors — fuel, the use of land, etc. 

8. The dependence of the price of cost goods upon the 
price of finished products is usually obscured by the fact 
that most cost goods are demanded by more than one 
industry. 

In a large area of the Northwest, the soil is equally well 
adapted for the growing of corn and of wheat. If the price 
of wheat falls, the rent on land formerly used for wheat 
growing will not necessarily decline. The land will simply 
be taken over by corn culture, and continue to yield the 
same rent. Here it appears that the necessity of paying 
rent exerts a controlling influence on the supply of wheat, 
and hence on its price. The labor which can be used in 
farming can also be used for railway building and for much 
of the unskilled work in the cities. If, then, the prices of 
farm products decline, the wages of farm labor may de- 
cline only slightly, if at all, since any reduction in wages 



THE COST OF PRODUCTION 87 

would drive laborers into other employments. In any single 
industry, the price of labor and of other cost goods is likely 
to be less subject to the control of the men engaged in the 
industry than is the price of the products of the industry. 
To double the output of a particular grade of cotton cloth 
would, under ordinary circumstances, reduce its price very 
materially. The expansion of the production of this grade 
of cloth would represent an increased demand upon the 
supply of raw material, of labor, and of fuel. But this in- 
crease might represent less than one ten-thousandth of the 
total demand for these factors in production, and would 
consequently exert scarcely a perceptible influence upon 
their price. It is natural, then, that practical men should 
regard costs as something fixed and independent of their 
control, while they regard the price of finished products 
as variable and dependent upon their action in producing 
or refraining from production. 

9. Where two centers of production compete freely with 
each other, the one may be able to drive the other out of cer- 
tain lines of industry. One cannot drive the other out of all 
lines of industry. 

It is often said that the South can manufacture cotton 
more cheaply than New England, and that therefore, since 
both sections must sell their products at practically the 
same price, cotton manufacture in New England is doomed. 
The advantages of the South are said to be cheaper labor 
and cheaper power. Let us see how long these advan- 
tages can be retained. 

As the South extends its production, the price of cotton 
goods declines. Possibly some New England mills are 
forced to shut down ; others, while continuing in operation, 
reduce their output. The expansion of the industry in the 
South increases the demand for labor and tends to raise its 
price. The contraction of the industry in New England 
reduces the demand for labor, and tends to lower its price. 



88 INTRODUCTION TO ECONOMICS 

Forces are therefore at work reducing the difference be- 
tween the two centers in labor cost. 

But the wages of cotton operatives depend not only 
on the fortunes of the cotton industry, but on the fortunes 
of other industries as well. A reduction in the wages of 
cotton mill hands in New England causes an efflux of 
such labor into other industries, and this tends to check 
the reduction in wages. In the South rising wages in the 
cotton industry is followed by an influx of laborers from 
other industries, and this tends to check the rise of wages. 
It is quite possible that, owing to the existence of other 
industries capable of absorbing labor on the one hand, 
or of yielding up labor on the other, the South will get a 
larger and larger share of the cotton industry, until it 
has taken over practically the whole business. 

Now let us suppose that all the industries of the South are 
in competition with all the industries of New England, and 
that costs are lower in the former part of the country than 
in the latter. An attempt on the part of all Southern 
producers to extend their outputs immediately forces up the 
price of all producers' goods — labor, fuel, and water power, 
etc. A tendency on the part of all New England producers to 
restrict production immediately reduces the price of pro- 
ducers' goods. It is, then, only for a brief time that all 
costs can be higher in one section than in the other. The 
higher price of labor might indeed induce the whole New 
England working population to migrate to the South ; but 
in no other possible way could the volume of New England 
industry be permanently restricted by Southern competition. 

The same reasoning applies to international competition. 
It is folly to talk of the probability that British industry 
will be driven to the wall by German and American com- 
petition. Wages and interest in Great Britain may be 
reduced by foreign competition, and this may induce men 
and capital to emigrate. This would reduce the volume of 



THE COST OF PRODUCTION 89 

British production, but it is impossible that the British man- 
ufacturer would in the long run find prices too low to cover 
costs. The latter adjust themselves to prices, and fall when 
general prices fall. 

10. Some costs manifest a more direct dependence on the 
price of particular finished products than do others. The 
former are therefore said to be price-determined ; the latter 
are said to be price-determining. 

In the making of bricks, the laborers employed are for 
the most part of a kind equally well suited for farm labor 
or for unskilled labor in the cities. The fuel used in 
burning the bricks might be put to a hundred other uses. 
The clay, on the other hand, can probably be used for 
nothing but for making bricks. 

Accordingly, if the price of bricks rises, this can hardly 
affect the price of labor or of fuel. For the price of these 
goods is derived from a wide range of production in which 
they are employed, and the making of bricks represents a 
negligible part of the demand for them. It is entirely 
different with the price of clay. If the available deposits 
are limited, this price may rise so high as to absorb prac- 
tically the entire gains resulting from the rise in the price 
of bricks. If the price of bricks falls, the loss is borne 
chiefly by the owner of the clay deposit. 

In a country whose agriculture consists almost exclu- 
sively in wheat raising, a rise in the price of wheat will 
raise wages of farm hands only slightly, as the rate of 
wages in agriculture must bear a close relation to the rate 
of wages in other unskilled pursuits. It will raise the rent 
of wheat lands, as the price of the use of such lands de- 
pends on their use for growing wheat, and on nothing else. 
It is easy, therefore, to see what the earlier economists 
meant when they said that rent is the effect, not the cause, 
of price. Rents, under certain conditions, rise or fall with 
the price of agricultural produce. Certain modern econo- 



9° 



INTRODUCTION TO ECONOMICS 



mists express the same thought when they say that rents 
are price-determined. Wages were regarded by earlier 
economists as the cause, not the effect, of price ; they are, 
said by some modern economists to be price-determining, 
not price-determined. As we have seen in the foregoing 
sections, a sufficiently broad view shows that the prices of 
all cost goods are derived from the prices of their products. 
And there are few cost goods so definitely restricted to a 
particular line of production that a reduction in their price 
in one industry does not result in a partial withdrawal of 
their supply, with a consequent reaction on price. 

11. Summary. 

Since prices normally bear a close relation to the costs 
of production, an ultimate explanation of prices involves 
an explanation of the forces determining costs. The 
general principle is that the prices of cost goods are de- 
rived from the prices of finished products. Accordingly, 
when the price of a finished product rises, this rise is re- 
flected first in the prices of those goods that enter into its 
production, and later in the prices of goods entering into 
the production of the cost goods. Under competition the 
benefits from a rise in the price of a finished commodity 
rest ultimately with the factors in production that are 
limited in quantity, either by natural or by social-economic 
conditions. 

If a production good is used in a large number of indus- 
tries, a rise or fall in the price of any single commodity 
into which it enters will have little effect upon its price. 
For to reduce the price of the production good in one indus- 
try would result in diverting it to other industries. A condi- 
tion of producing a finished commodity is a price sufficient to 
pay the usual rate for production goods of this kind. Such 
goods are therefore in a price-determining position. The 
production goods which can be used in only one industry 
rise or fall in price with the products of that industry. 



CHAPTER VI 
THE LAW OF DIMINISHING RETURNS 

1. Increase in the output of an industry is normally checked 
by increase in the cost of some factor in production, due to the 
difficulty encountered in increasing the supply of that factor. 

In the last chapter we saw that one of the forces limiting 
the expansion of an industry is the tendency of costs to 
rise to the selling price of the product of the industry. The 
American cotton-spinning industry may be very profitable 
this year- — that is, the margin between the selling price of 
cotton yarn and the cost of producing it may be wide. But 
before long an expansion of the industry will take place ; 
increasing demands upon the existing supply of skilled 
labor, of raw cotton, and of other factors in the production 
of cotton yarn will force the expenses of the enterprisers 
engaged in the industry to a higher level. 

We saw further that not all elements in cost show the 
same tendency to increase. In cotton spinning, part of the 
labor force is skilled, part of it unskilled. If the industry 
were to expand, say, by fifty per cent, a great strain would 
be put upon the supply of labor specially trained for cotton 
spinning. No perceptible strain would be placed upon the 
supply of unskilled labor, for outside of the spinning indus- 
try enormous quantities of unskilled labor are to be had. 
The skilled labor might therefore for a time enjoy a large 
increase in wages, while the wages of unskilled labor would 
scarcely be affected at all. 

Similarly, such an expansion of the industry would 
represent a great strain upon the supply of raw cotton, 
which for a year could not be increased. Quite possibly 
the price of raw cotton would be doubled. The same 

91 



92 INTRODUCTION TO ECONOMICS 

expansion of the cotton-spinning industry would result in 
an increased demand for coal for power. But the use of 
coal is so universal, and the volume of its consumption so 
vast, that the increased demand from the cotton industry 
would be a negligible factor in influencing its price. Coal 
would probably not rise perceptibly. 

2. The individual enterpriser usually finds himself 
hampered in his efforts to increase his business by the dif- 
ficulty of increasing his supply of some of the factors entering 
into his production. 

For a somewhat different reason, the output of a single 
enterpriser can often be increased only at increasing cost. 
It is true that one enterpriser out of a multitude cannot 
force up the wages of labor against himself, as a whole in- 
dustry can do. Nor can he exert any perceptible influence 
upon the price of raw material and other supplies. But 
there are usually certain factors entering into his produc- 
tion that, so far as he is concerned, are either limited abso- 
lutely, or can be increased only at a disproportionately 
heavy outlay. In any agricultural section you may find an 
enterprising farmer forced to limit his operations to a single 
hundred acres. He can hire as many men as he pleases at 
$25 a month, the price he pays his one "hired hand." He 
can buy additional teams and additional machinery at no 
advance over the price of those he already has. Why 
does he not buy or rent additional land, and carry on a 
large scale business ? Because all the adjoining lands are 
occupied by men who prefer to till them with their own 
labor and who would consequently demand a very high 
rental, if they consented to give up their land. Our farmer 
might be compelled to go a distance of three or four miles 
to get additional land at reasonable rates. Of course land 
cannot be advantageously cultivated from such a distance. 
Hence he is forced to content himself with his own one 
hundred acres. 



THE LAW OF DIMINISHING RETURNS 93 

In almost any town you may find a bright and capable 
young grocer, conducting the pettiest corner grocery busi- 
ness. The possibilities of trade may be numerous ; a store 
ten times as large might easily be supported by the potential 
custom. Why then do we find a little store ? The young 
merchant might easily rent larger premises, without more 
than a proportionate increase in rent. He might hire as 
many clerks and delivery boys as he wished, without pay- 
ing a rate of wages in excess of the rate he pays to the 
one or two already in his employ. What he especially 
lacks is capital. Perhaps he has $5000 of his own. The 
cost which the use of this capital represents is merely the 
interest he could get at a savings bank — say, four per cent. 
With $5000 capital of his own, he may be able to borrow 
another $5000 at six per cent. For an additional $5000 
he would probably have to pay ten per cent, as the security 
he has to offer is not so good. It is unlikely that he can 
borrow more capital, no matter how high a rate of interest 
he may be willing to pay. The maximum business he can 
conduct, then, is one for which a capital of $15,000 will 
suffice. 

A small stream, flowing between high, rocky banks, 
may offer an excellent opportunity for the establishment of 
a factory to be operated by water power. Let us suppose 
that a manufacturer, acquainted with the advantages of the 
location, decides to erect a mill. He may be able to com- 
mand practically unlimited capital. Whether his mill will 
require one hundred hands or one thousand will make no 
difference in the rate of wages he will have to pay. Raw 
material can be obtained at least as cheaply in large lots as 
in small. Plainly, what will determine the size of the fac- 
tory will be the power to be obtained from the stream. A 
ten-foot dam will give a certain power ; a twenty-foot dam 
a much greater one, and every additional foot in height of 
dam means additional power. But there is an absolute limit 



94 INTRODUCTION TO ECONOMICS 

to the height to which the dam may reach, without forcing 
the stream above its banks and ruining a large amount of 
property on the lower levels adjacent to it. There may also 
be limits of expense ; after the dam has reached a height 
of twenty feet, further addition to its height may imply such 
a great increase in its length and in the character of the 
materials required to stand the increased strain that the 
additional power is not worth its cost. 

It will not be necessary to multiply instances further. 
If the reader will examine the various businesses with 
which he is acquainted, he will observe that in a large pro- 
portion of them it is difficult, if not impossible, to duplicate 
all the elements in production without incurring dispropor- 
tionate expense. 

3. In some cases an absolute limit is placed tip on produc- 
tion when one of the factors cannot be increased in amount. 
In most cases, by the application of increased amounts of the 
other factors, production may be increased, but with con- 
stantly greater difficulty. 

Among the products of industry are many chemical 
compounds, the components of which are combined in 
perfectly definite proportions. A shortage of fifty per 
cent in the supply of any component entails a shortage of 
fifty per cent in the finished product. In most cases, 
however, the producer can vary the proportions in which 
economic elements in production are combined. A 
bushel of wheat may be produced on a relatively large 
area with the application of a small amount of labor, or 
on a relatively small area with the application of a large 
amount of labor. Cotton cloth may be woven with rela- 
tively small expenditure of labor and large expenditure 
of power, or with large expenditure of labor and small 
expenditure of power. Even a slight acquaintance with 
actual business conditions gives ample illustration of 
the fact that in every industry there is great variety in 



THE LAW OF DIMINISHING RETURNS 95 

the proportions in which the various producing factors are 
combined. Accordingly, if a business man is confined to 
a limited supply of one factor, he may yet increase his 
operations by selecting a method which involves small use 
of the limited factor and large use of the other factors. 

4. An increase in the amount of labor and auxiliary capi- 
tal employed upon a given area of land does not, as a rule y 
result in proportionate increase in product. 

Let us return now to the case of the farmer, confined to 
his one hundred acres of tillable land. By his own labor 
and with a single team and the appropriate machinery he 
may till the whole tract. Fifty acres, we may imagine, are 
put into wheat, fifty acres into corn. In the time for sow- 
ing wheat, a few good days may be followed by a week of 
rainy weather. Half of the wheat field may be sowed in 
time to get the benefit of the wet weather ; the other half 
of the field may have to be left until the ground is dry, 
and so this part of the crop will lose the advantage of an 
early start. Similarly, part of the corn planting may be 
belated, with resultant danger to the crop from early frosts. 
There may not be enough dry days in the late spring to 
enable the farmer to keep his cornfield free from weeds. 
In harvest time, the chances of loss from delays in cutting 
and stacking the wheat are still greater. Of course these 
adverse chances may not be realized. The weather may 
be dry just when it should be ; the rains may come just 
when they are wanted. But experience proves that the 
weather is not thus happily regulated. One year with 
another, our farmer will be fortunate if he gets twelve 
bushels of wheat and forty bushels of corn per acre. 

Instead of tilling the whole tract with his own labor, 
the farmer- may hire a man to help him. He buys an 
additional team, plow, harrow, cultivator, etc., practically 
duplicating his stock of machinery as well as his supply of 
labor. The land can now be much more carefully tilled; 



96 INTRODUCTION TO ECONOMICS 

it will almost surely yield a greater aggregate return. 
Will the return be doubled ? It would be unreasonable to 
expect this. More probably, the wheat yield will increase 
to fifteen bushels ; the corn yield, to fifty bushels. 

Now let us imagine that the farmer employs a second 
hired laborer, and invests an additional $500 in a team and 
machinery. How much will be added to the crop ? It is 
unlikely that the addition will be as great as that resulting 
from the employment of the first hired workman. We 
will assume that the wheat crop per acre is increased to 
seventeen bushels, the corn crop to fifty-five. With a third 
hand the crop of wheat would perhaps increase to eighteen 
bushels, and the crop of corn to fifty-eight. A fourth 
hand might increase the crop of wheat to eighteen and 
one-half bushels ; that of corn, to fifty-nine bushels. There 
is no reason why every additional workman should not 
make some small addition to the crop, until the wheat crop 
had become fifty bushels and the corn crop one hundred 
and fifty. 

An important principle, involved in this example, may 
now be stated. From a given area of ground, an amount 
of produce can be obtained increasing with every increase 
in the labor and auxiliary capital employed in tillage, but 
increasing less than proportionally with the increase in 
labor and auxiliary capital. This principle is called the 
law of diminishing returns in agriculture. 

5. Returns diminish more rapidly in some branches of 
agriculture than in other branches. 

Some crops are far more responsive to the efforts of the 
husbandman than are others. If a wheat field is well fer- 
tilized and properly prepared to receive the seed, it may 
yield twenty bushels per acre. An American farmer would 
find it next to impossible to raise the yield to forty bushels, 
even at the expenditure of almost unlimited pains. A 
similar field, prepared in the ordinary manner, may yield 



THE LAW OF DIMINISHING RETURNS 97 

fifty bushels of potatoes per acre. By extreme care in 
selecting the seed and in keeping the field free from weeds 
and from insects the yield might possibly be raised to two 
hundred bushels, or even much more. It is more feasible 
to quadruple the potato crop than to double the wheat 
crop. In the production of many garden vegetables and 
small fruits, the returns to extraordinary care are often 
almost incredible. Indeed, it has sometimes even been 
doubted whether the law of diminishing returns is oper- 
ative in the growing of such products. There can be no 
doubt that doubling the amount of labor expended upon a 
given area in gardening often increases the output by more 
than one hundred per cent. But it is self-evident that a 
point must eventually be reached where a doubling of the 
expenditure for labor will fail to double the output. 

6 . If the amount of capital expended in improving a given 
urban building site is increased, the returns do not increase 
proportionately with the increase in capital. 

The principle of diminishing returns, as it operates in 
agriculture, was first formulated by economists more than 
a hundred years ago, although practical men have, of 
course, taken account of it in their business conduct ever 
since agriculture became man's chief source of food. The 
applicability of the principle to land devoted to trading and 
manufacturing purposes was for a long time ignored by 
economists. This may be explained by the fact that 
formerly urban land was so cheap that the small amount 
required for the erection of a shop or a factory represented 
an almost negligible element in the total costs of carrying 
on a business of this nature. The enterpriser rarely found 
himself forced to adjust his business with a view to obtain- 
ing the greatest possible use from a definite amount of 
land. If his capital sufficed for so large a business, he 
purchased or leased a city block on which to erect his build- 
ings ; if his capital was small, he limited his use of land to 



98 INTRODUCTION TO ECONOMICS 

a few lots. To-day conditions have changed, in conse- 
quence of the extraordinary growth of the cities. The 
merchant who desires to carry on a business in the heart 
of the business district of a great city often finds himself 
restricted to a given number of front feet. The adjacent 
lots are taken up by establishments which show no dis- 
position to remove. It is then a question how to conduct 
a maximum paying business upon a fixed ground space. 

One way of overcoming the limitation of ground space 
consists in erecting a very lofty building. Instead of con- 
tenting himself with a building of six stories, the enter- 
priser may push the height to fifteen or more. Perhaps 
it costs $600,000 to erect a six-story building. An ad- 
ditional $100,000 may possibly give another story; but 
more probably the seventh story will, in effect, cost more 
than this. To raise the building materials to this height 
is more expensive than to raise materials to a lower story. 
Moreover, a seven-story building is not merely a six-story 
one with a floor superadded ; in planning the taller build- 
ing, it is necessary to allow for greater strength of wall in 
the lower stories, in view of the additional weight to be 
borne by them. Greater care must be exercised to reduce 
risk from fire. In addition to the increased cost of con- 
struction, there will be greater costs in connection with the 
permanent use of the seventh floor than in connection with 
the use of lower floors. More labor will be spent in carry- 
ing up the goods to be exposed for sale, and in carrying 
down the articles sold. More numerous and more power- 
ful elevators will be required for the higher building. We 
may therefore place the initial cost of the additional floor 
at $120,000. 

An eighth floor would, in effect, cost still more than the 
seventh — $140,000, let us say. A ninth floor may cost 
$160,000; a tenth floor $180,000, and the fifteenth floor 
may cost $280,000. As there is no reason for supposing 



THE LAW OF DIMINISHING RETURNS 99 

that the higher floors will accommodate more business 
than the lower, it is clear that the returns on capital 
expended diminish with each additional floor. 

7. The principle of diminishing returns is illustrated by 
the results of increasing the rolling stock of a transportation 
company without increasing trackage. 

In a certain city a street railway company, let us assume, 
has extended its lines of track through all the streets which 
promise any considerable traffic. The trackage is then a 
fixed element in the company's business, analogous with 
the land of the farmer or the floor space of the merchant. 
The variable elements are labor, fuel for power, and aux- 
iliary capital in the shape of cars. 

With one hundred cars in the entire system, running at 
intervals of twenty minutes, the company may carry an 
average of one hundred passengers per car per trip, thus 
earning $$. It is easy to see that the number of pas- 
sengers carried would be increased if the service were 
more frequent. Persons who have only a short distance 
to go will form the habit of walking, if the alternative 
usually means waiting fifteen or twenty minutes for an 
overcrowded car. Quite possibly the company would get 
twice as many fares with two hundred cars, running at 
intervals of. ten minutes. In this case the tendency of 
returns to diminish does not appear. 

Imagine now that the company places a third hundred 
cars upon its lines, still further reducing the intervals be- 
tween cars. In large measure these cars will simply carry 
passengers who would have been carried by the other 
cars ; and this is, of course, no gain to the company. The 
greater efficiency of the system, and the greater comfort 
of riding in cars that are never overcrowded, will develop 
some increase in traffic. Possibly this increase will amount 
to fifty passengers for each of the new cars. Each of the 
new cars would thus represent an addition of $2.50 to the 



ioo INTRODUCTION TO ECONOMICS 

income of the company. An additional hundred cars may- 
increase the number of passengers carried by an average 
of twenty-five for each additional car; still another hundred 
may increase the number of passengers carried scarcely 
at all. 

8. The principle of diminishing returns comes into opera- 
tion when the amount of labor increases, while the amount 
of capital remains fixed. 

The element in production which operates to limit the 
expansion of a given business may be capital in its general 
form, not any concrete productive good. It is a fortunate 
business man who finds his capital limited only by the 
possibilities of profitable employment which he commands. 
In practical life a man can secure for use in his business, 
besides his own capital, only the additional capital for 
which he can give security. And this is usually limited to 
some proportion of the value of his own property. 

Assuming that a manufacturer possesses a capital of 
$50,000, and can borrow $50,000 more, the sum $100,000 
limits his operations as narrowly as any other fixed element 
in his production could do. He has, of course, many 
choices as to the exact disposition of the capital. If he is 
engaged in cotton manufacture, he may use first-class 
machinery, or he may employ a poor grade of machines — 
perhaps machines that have been discarded in other sec- 
tions, as was for a long time a common practice in the 
South. He may decide upon investing $50,000 of his 
capital in looms, and the remainder partly in the building 
and partly in materials, etc. With twenty-five laborers and 
high-grade looms, the output per laborer will be high ; with 
fifty laborers and lower grade looms, the output per laborer 
will probably be less, although the total output of the mill 
will be increased. A third force of twenty-five laborers 
with a still cheaper grade of looms will add something to 
the total output, but the output per man will be still further 



THE LAW OF DIMINISHING RETURNS 101 

diminished. Perhaps the output per man, when twenty-five 
are employed, will be $2000. With cheaper looms and 
fifty men, the output per man may be $1900. Seventy-five 
men, with the capital put into appropriate form, might 
produce $1800 per man. With one hundred men, the 
returns per man might be $1700, and with each further 
addition to the number of men a corresponding decrease 
in product per man might take place, until at last additional 
laborers added nothing to the output. 

9. The principle of diminishing returns is of universal 
application in tJie field of production. 

Wherever one element in production is fixed, while the 
other factors in production increase, the principle of 
diminishing returns inevitably operates. Wherever one 
factor in production increases, while the other factors in- 
crease at a more rapid rate, the law of diminishing returns 
operates, but in modified form. If the labor and movable 
capital of society increase while the natural resources at 
the command of society fail to increase, diminishing returns 
appear, as in the individual establishments of our examples. 

We may now state the law of diminishing returns in its 
general form. When any one of the several factors whose 
cooperation is essential to production is limited in quantity, 
either absolutely, or by conditions of increasing cost, while 
the quantity of the other factors may be increased practically 
without limit, every ttnit of increase in the variable factors 
results in an increase of output less than proportionate to the 
increase in the variable factors. 

10. Economy in production is at its maximum when the 
final expenditure on the variable factors just equals the 
return to those factors. 

The manufacturer who erects a mill to utilize the power 
obtained by damming a stream, is limited in his operations 
by the power represented by the head of water. This is 
the fundamental limiting element in his calculations. But 



102 INTRODUCTION TO ECONOMICS 

it is not to be supposed that the power which he will actu- 
ally obtain is a definite quantity. Human ingenuity has 
devised no means whereby all the power actually resident 
in any natural source may be transmuted into a form which 
lends itself to use. All our devices for securing and trans- 
mitting power are imperfect ; the best of them are only 
less wasteful of energy than the worst. Our manufacturer 
may install a mechanism which costs little but permits a 
large part of the power to go to waste, or he may install 
a more complicated and costly set of devices, which will 
come far nearer turning to account the whole power repre- 
sented by the fall. We may think of the manufacturer as 
weighing the advantages of different kinds of power plant. 
The expenditure of $1000 will permit the utilization of, per- 
haps, one half of the power. A second $1000 may make 
it possible to utilize two thirds of the power. With a plant 
costing $3000 perhaps three fourths of the total power will 
be utilized. A $4000 plant may utilize four fifths of the 
power, and so on. At what point will it be more profitable 
to let power go to waste than to incur additional expense 
to save it ? On© half of the power may have a value of 
$300 per year. Interest and depreciation on the $1000 
necessary to obtain this power may amount to $150. The 
value of the power which would be obtained through the 
$2000 plant, on the basis we have assumed, would be $400 ; 
and the cost, figuring interest and depreciation as before, 
would be $300. The simple plant therefore would yield a 
net value of $150 above cost; while the more complicated 
plant would yield only $100. It would accordingly pay 
best to install the $1000 plant. If the value of the power 
should double, however, while the cost of the several kinds 
of power installations remained unchanged, the $1000 plant 
would yield a value of $600 at a cost of $150, leaving a net 
gain of $450; while the $2000 plant would give a power 
worth $800 at a cost of $300, leaving a net gain of $500. 



THE LAW OF DIMINISHING RETURNS 103 

The $3000 plant would yield a power worth $900, but at a 
cost of $450. The net gain is evidently diminished through 
the installation of the $3000 plant. The $2000 plant is, 
under the circumstances, the most economical available. 
Were the value of the power again doubled, the $3000 
plant would yield the highest surplus above cost, and so 
would be the most advantageous economically. 

Under present conditions it is an excellent steam engine 
which transforms into mechanical power one sixth of the 
energy of the coal which it consumes. A simple and inex- 
pensive type of engine does not do nearly so well as this. 
At a given place and time, will it be more economical to 
employ an engine of the very highest type, and which 
naturally is very costly, or an inexpensive engine of a sim- 
ple type ? The former may transform into power fifteen 
per cent of the energy latent in the coal ; the latter, only 
five per cent. If the additional power obtained through the 
better engine does not equal the excess of interest and 
depreciation charge on the more costly engine, the simpler 
engine is the more economical in spite of its wastefulness 
from the mechanical point of view. 

A farmer should continue his application of labor and 
capital to land as long as the returns from additional units 
of labor and capital exceed their cost. If wages and 
interest decline, it becomes possible to increase the ap- 
plication of labor and capital to land without passing be- 
yond the bounds of economical production. Similarly, 
cultivation may profitably be made more intensive if the 
prices of agricultural products rise. We have here an ex- 
planation of the fact that in old countries land is cultivated 
more intensively than in new countries. In the latter 
wages and interest are high and prices are low. 

11. The law of diminishing returns may be counter- 
acted by improvements in production. 

Improvements in methods of production are constantly 



104 INTRODUCTION TO ECONOMICS 

taking place, with the result that a given amount of labor 
or of capital increases in efficiency. If the amount of labor 
employed upon a hundred-acre field increases, the increase 
in product will not ordinarily be proportionate to the in- 
crease in labor. But if at the same time a new way of 
cultivating or fertilizing the soil is discovered, or if the 
quality of the seed is improved, the product may very well 
increase relatively to the amount of labor. This fact does 
not prove that the law of diminishing returns is non-exist- 
ent. It merely proves that there are other forces at work 
which may, at times, neutralize its effects. These forces 
are, of course, of the greatest practical importance, and 
will later demand our attention. 

Another qualification of the principle of diminishing 
returns consists in the fact that the very process of in- 
creasing the number of units of variable factors employed 
in connection with an unvarying factor may, under certain 
conditions, increase the productive efficiency of each 
unit of the varying factors. To employ two men on an 
acre of land that could be cultivated by one would result in 
a diminished return per man if each worked alone. But 
many tasks may be better performed when two or more 
men cooperate than when each works by himself. Accord- 
ingly, it may happen that an increase in labor which makes 
cooperation possible, or an increase in capital which makes 
possible better methods, may be accompanied by increasing, 
instead of diminishing, returns. 

12. Summary. 

In most businesses the enterpriser is subject to definite 
limitations in his control over one or more of the factors 
upon which his production is based, while he may be able 
to increase other factors without assignable limits. Such 
limitations upon some of the factors in a productive com- 
bination do not necessarily place an absolute limit upon 
the size of a business ; they do, however, imply that after 
a certain size has been reached, further expansion involves 



THE LAW OF DIMINISHING RETURNS 105 

disproportionate expense. This principle, known as the 
law of diminishing returns, is of universal applicability in 
the field of production. 

The greatest economy in production is attained when 
the returns to the last units of the variable factors in a 
business just equal the cost of those factors. Every reduc- 
tion in the cost of one of the variable factors extends the 
scope of profitable application of that factor. The law 
of diminishing returns may often be counteracted by im- 
provements in production ; in some cases this counteract- 
ing influence may be brought about by the very forces that 
tend to bring the law of diminishing returns into operation. 



CHAPTER VII 

THE SPECIALIZATION OF ECONOMIC FUNCTIONS 

1. In primitive conditions all the functions of wealth pro- 
duction are performed by the single kinship group, or family. 

At the dawn of civilization men lived in small groups 
that were practically self-sufficing. Whatever work was to 
be done was executed by all the men in cooperation, or by 
any member of the tribe indifferently. Some distinction 
there was between the work of men and that of women ; 
the former were in many cases engaged chiefly in hunting, 
the latter in root grubbing and in a primitive form of gar- 
dening. Economic differentiation, then, hardly existed. 
It is true that there was little occasion for the specializa- 
tion of economic functions, since wants were few and 
economic functions were consequently simple. 

In many cases civilized men have been placed in condi- 
tions that bear a superficial resemblance to those of primi- 
tive life. But the civilized man carries with him a great 
number of wants that the savage never experienced. We 
therefore find, in such conditions, a progress in the differen- 
tiation of economic functions taking place in a few decades, 
while in the history of the human race as a whole, differen- 
tiation was the result of thousands of years of development. 

In a frontier community, where almost the entire popu- 
lation consists of independent families living upon farms, 
the economic functions performed by each person are 
numerous and diverse. The frontiersman must, in the first 
place, be an agriculturist and a grazier. Each of these 
occupations includes numerous functions calling for differ- 
ent qualities, the agriculturist being a plowman, sower, 
reaper, etc. The frontiersman must also be a woodcutter 

1 06 



SPECIALIZATION OF ECONOMIC FUNCTIONS 107 

at times, a carpenter, a mason, a cabinet-maker, a smith, a 
butcher, and a hunter, not to speak of a host of miscellaneous 
functions that he must occasionally perform. His wife 
probably has a no less varied array of occupations. She 
is a cook, a laundress, a seamstress, a dairymaid, a spin- 
ner, a weaver, a nurse, and a teacher. To survive on the 
frontier one must be a jack of all trades. And practically 
the same range of duties falls upon the strong and the weak, 
the intelligent and the dull, the man who quickly acquires 
skill and the man who acquires it with great difficulty. 

2. The first stage in the differentiation of economic func- 
tions is the exchange of services. 

Were the frontier community wholly isolated for many 
generations, a transformation of its methods of production 
would gradually take place. A person with more than the 
ordinary talent for building would be called upon to assist 
in the construction of his neighbors' houses, receiving in 
return assistance in work for which he had no special quali- 
fication. Little by little, occupations would be differenti- 
ated, and eventually the community would contain among 
its population carpenters, smiths, masons, weavers, etc. 
While these craftsmen might still own land, and spend their 
odd hours in agriculture, the main source of their livelihood 
would be the exercise of their several crafts. Specialization 
in the form known as differentiation of occupations would 
thus have come into existence. 

So long as differentiation of functions rests upon a direct 
exchange of services, it cannot be carried far. Population 
would need to be fairly dense before a man could devote 
himself exclusively to the building of houses, even if he 
undertook the work of stone mason, brick mason, and 
plasterer in addition to that of carpenter. Such trades as 
that of locksmith could hardly exist at all, since a scattered 
rural population could scarcely furnish work enough to 
maintain it. 



108 INTRODUCTION TO ECONOMICS 

3. An important step in the direction of economic speciali- 
zation was taken when men began to produce commodities 
for sale. 

In early modern times the development of trade gradu- 
ally transformed production for the household into produc- 
tion for the market. This change first made its appearance 
in the woolen industry. At first, we may suppose, only 
the surplus of domestic production was placed upon the 
market of the town, or carried to fairs where a larger con- 
course of purchasers was to be found. In time production 
for domestic use became a mere incident ; the weaver came 
to depend on more or less distant markets for the sale of 
his wares. And this implied the purchase in the market 
of the materials of production. So we find German weavers 
in the fifteenth century carrying their wool from England 
and their finished products to southern and eastern Europe. 
Under these conditions there was no reason why a man 
should produce more than one kind of cloth. A great body 
of consumers was within his reach, and however special his 
product, he could devote himself exclusively to it. 

In like manner, traders would soon appear in the frontier 
community of our example, and carry away the lighter sur- 
plus products, giving in exchange the manufactured goods 
of older communities. A railroad would, in time, transform 
the frontier community into an integral part of the civilized 
world. Instead of weaving its own cloth, it would barter 
its surplus products of the soil for textiles produced in other 
parts of the world. The community as a whole would thus 
be specialized to the functions best adapted to its conditions. 

As the community advanced in numbers and wealth one 
function after another would be taken out of the province 
of the man of all work, and given over to persons specially 
qualified by nature and training to perform it effectively. 
Each trade, again, would tend to subdivide. The carpen- 
ter would no longer plan the building upon which he 



SPECIALIZATION OF ECONOMIC FUNCTIONS 109 

worked, this function being given over to the architect. 
The planing of boards would cease to be a part of the car- 
penter's work, as planing mills would be established which 
would do the work far more economically. Even in agri- 
culture some differentiation would take place ; one man 
would devote himself chiefly to the growing of grain, an- 
other to raising vegetables, etc. Owing to the seasonal 
character of agricultural labor, however, and the advan- 
tages of combining crops in such a way that the work may 
be distributed as evenly as possible throughout the open 
months, specialization in agriculture could not be carried 
very far. Indeed, even in the best developed agriculture, 
we do not find some farmers wholly devoted to wheat cul- 
ture, others growing nothing but corn, others potatoes or 
turnips. Agriculture by its nature precludes a high degree 
of differentiation of functions. 

4. Differentiation of function in production is in large 
measure dependent upon the character of the existing com- 
mercial organization. 

In the mediaeval towns the artisan was at the same time 
a trader. He was compelled to supply himself with mate- 
rials, often from distant sources; he was often compelled 
to carry his wares from place to place in order to find 
purchasers. The risks incident to procuring materials and 
marketing products weighed heavily upon him. Cooper- 
ation, as in the German Hanse towns, reduced his difficul- 
ties in some measure; nevertheless, under the conditions, 
comparatively few men could rely for their subsistence 
upon a single occupation. With the development of a 
merchant class, the producer was relieved of the labor and 
risks of assembling materials and marketing products. The 
accumulation of large and permanent stocks of material 
gave occasion for a constantly increasing number of occu- 
pations, or subdivisions of occupations. 

As an illustration of the effect of commercial develop- 



no INTRODUCTION TO ECONOMICS 

ment upon the division of labor, we may cite the industry 
of shoe manufacture. One hundred years ago shoe mak- 
ing was carried on by independent cobblers, supplying a 
local demand. Every cobbler made many types of boots 
and shoes. At a somewhat later period, shoes had become 
an article of commerce, and the cobbler ceased to be de- 
pendent on the local demand. In the next stage in the 
process of development, the commercial demand for shoes 
had become too important to allow the supply to remain 
dependent upon the enterprise of the independent cobbler. 
The merchant began to furnish material ready cut to be 
sewed and pegged by persons capable of doing the work, 
whether trained in the trade or not. In this stage the 
simpler processes were performed by one set of hands, the 
more complicated by another. Thus division of labor had 
succeeded differentiation of occupations. Further improve- 
ments in methods of marketing the finished product led to 
still more minute division of labor, under the factory form 
of organization. To-day each shoe goes through scores of 
hands before it is placed on the market as a finished 
product. 

A similar evolution may be traced in the ready-made 
clothing industry — a still newer field. The retail and 
wholesale clothing trade has grown up in the last fifty 
years; its increasing demands have given a stimulus to 
the differentiation of functions in the making of clothes. 
It is, of course, to be borne in mind that in all cases the 
development of trade and the differentiation of economic 
functions have proceeded concurrently. Each has been 
in part the effect, in part the cause, of the other. 

5. Improvements in transportation give occasion to in- 
creased specialization in industry. 

Division of labor first reached a high degree of develop- 
ment in centers enjoying water transportation. Until 
recent times, it was only at such centers that the more 



SPECIALIZATION OF ECONOMIC FUNCTIONS in 

bulky materials of industry could be assembled in suffi- 
ciently large quantities to permit extensive subdivision of 
functions ; furthermore, it was only from such centers that 
it was possible to carry bulky goods to a great number of 
consumers. The advent of the railway enabled inland 
cities to engage in highly specialized production. As rail- 
way service became better and cheaper, many forms of 
industry permitting a minute division of labor appeared. 
Until refrigeration had been reduced to a science, and the 
methods of transporting products preserved by ice had been 
perfected, every locality depended for its supply of meat 
upon the local butcher. If the consumers in the vicinity 
were few, they were ordinarily supplied by small shops 
which permitted only a low degree of division of labor. In 
the cities, the shops were larger, and division of labor was 
carried farther. To-day there is almost no limit to the 
market for a single establishment. Fresh meats from 
Chicago may be found in practically any city or town in 
the land. Fresh mutton killed in New Zealand and 
Australia finds a ready market in England. The parallel 
development of live stock transportation has given the 
slaughtering centers a practically unlimited supply of raw 
material. Accordingly, a minute division of labor has been 
evolved in the slaughterhouses. In the Chicago slaughter- 
houses the killing and dressing of a bullock is subdivided 
into fifty or sixty separate functions, each assigned to a 
separate set of workmen. Each set makes some small 
change in the material and passes it on to another set. 
Of course some functions are performed by single work- 
men, some by several. The laborers are organized in 
gangs of 230 men, each gang containing just the appro- 
priate number of men of each class. 

6. In the field of production at the order of the consume? ; 
division of labor is dependent largely upon the density of 
population. 



112 INTRODUCTION TO ECONOMICS 

Where the producer of a commodity deals directly with 
the consumer, the opportunity for minute division of labor 
is not so great as where the producer is brought into rela- 
tion with the consumer through the intermediation of a 
general market. The amount of work that may be secured 
by a single custom-tailor's shop is limited by the number of 
purchasers of custom-made garments within easy distance. 
In a village this number may be so small that anything 
like subdivision of the tailor's trade is impracticable. In 
a large city the case is different. A single shop may easily 
find customers enough to keep twenty men at work. In 
the latter case division of labor is entirely practicable. If 
transit facilities in the large city are excellent, the number 
of men that may be employed by a single tailoring estab- 
lishment may be one hundred or more, and labor may be 
as minutely subdivided as the employer desires. In the 
making of furniture at the order of the consumer, similar 
limitations upon division of labor are found. The small 
town is able to support only a small shop, where all the 
work is performed by two or three men, while the large 
city renders possible the large shop, with minute subdivi- 
sion of labor. 

7. The degree in which the functions of production may 
be subdivided is dependent upon the prevailing form of eco- 
nomic organization. 

Where each workman is his own employer, as was gen- 
erally the case in the mediaeval industrial organization, 
labor cannot be very minutely subdivided. In such an 
industrial organization the spinner buys his wool and sells 
his product to the weaver; the latter sells the cloth to the 
fuller, who, in turn, sells it to the dyer. The product is 
again sold, perhaps, to the shearer, who in turn sells the 
finished cloth to the draper, who deals directly with the 
consumer. With such a form of organization much time 
is necessarily wasted in the buying and selling of the mate- 



SPECIALIZATION OF ECONOMIC FUNCTIONS 113 

rial in its several stages, and the greater the number of 
stages, the greater the waste from this source. Again, as 
each person follows his own taste in choosing his trade — 
subject, of course, to family tradition and trade restrictions 
— it is unlikely that the society will have just the right 
number of craftsmen of each kind. At one time there will 
be too many spinners, relatively to the number of weavers ; 
at another time fullers will be so numerous that not all can 
be employed. And this element of waste also increases 
with increasing subdivision of labor. 

Where, on the other hand, industry is carried on under 
the factory system, the workmen are assembled under one 
roof, subject to the control of an employer. The material 
passes through the shop without interruption, and appren- 
tices are taken on in each branch in the proportions which 
experience shows to be most desirable. Of course this 
implies a large accumulation of wealth on the part of the 
employer, who must provide the premises, furnish materials, 
pay wages, and assume all other expenses of production. 
In fact, we may say that large capital and efficient manage- 
ment are prerequisites to a thoroughgoing system of divi- 
sion of labor. And, of course, efficient management on 
the part of the employer implies a corresponding readiness 
to submit to direction on the part of the employee. We 
might easily conceive of a society in which all other condi- 
tions requisite to division of labor might exist, but in which 
division of labor of an advanced type would, nevertheless, 
be impracticable on account of the restlessness of the 
working population under close direction. 

8. From a business point of view, the principal advan- 
tages of division of labor are ( 1 ) increased skill and speed 
in production ; (2) less waste of time ; (3) greater ease of 
supervision. 

To enumerate all the advantages of the division of labor 
would require a volume ; but we may group the more 



H4 INTRODUCTION TO ECONOMICS 

important ones under a few heads. In the first place, the 
limitation of the labor to be performed by one man to a 
single function, which involves the use of a single tool, 
and which may be reduced to a few simple movements, 
makes possible accurate workmanship and great speed, 
with relatively little weariness. The workman soon re- 
duces his movements to a rhythm ; he grasps each piece 
of material in the same way, delivering his strokes upon it 
in such a way as never to throw away his energy. Every 
one knows how much better results a trained oarsman 
secures from the expenditure of a given amount of muscu- 
lar energy than the raw beginner, who puts forth his 
strength now on the water, now on the air, now in the 
right direction, now in the wrong one. The difference in 
effectiveness between the strokes delivered by the man who 
works with a single tool, and the strokes delivered by one 
who works with a dozen tools, is hardly exaggerated by 
the comparison. 

The best workman loses some time in changing from tool 
to tool. It is not difficult to find a carpenter who spends 
many fruitless moments searching now for his saw, now for 
his hammer, while the whereabouts of the plane or square, 
when these implements are needed, proves a baffling, if not 
insolvable, problem. And this is the man who leaves his 
work with the loudest complaints of his weariness. A divi- 
sion of labor that holds a man so strictly to business that 
he never has a chance to stop to search for anything, con- 
tributes materially to reduce such waste of time and energy. 

The simplification of the task of each laborer makes it a 
comparatively easy matter to ascertain how much any par- 
ticular one is actually doing. One who has lived in tHe 
country has probably made the acquaintance of two types 
of laborers : the first, those who are always bustling 
about in a hurry and yet accomplishing little ; the second, 
never in a hurry, yet showing, in the end, a good record of 



SPECIALIZATION OF ECONOMIC FUNCTIONS 115 

achievement. Because of the miscellaneous character of 
the work of the agricultural laborer, it takes a long time to 
measure the relative efficiency of different men. Where a 
man is compelled to repeat the same operation throughout 
the day, no show of bustling energy will create the illusion 
of achievement. The pieces of work done have simply to 
be counted to give an accurate idea of the laborer's effi- 
ciency. It is obvious, then, that the difficulty of supervi- 
sion is greatly reduced by systematic division of labor. 

9. From a social point of view, the principal advantages 
of division of labor are : ( 1 ) that it affords a place of useful- 
ness to many who would otherwise be of little tise to society; 
(2) that it permits each to put his abilities to the best account; 
and (3) that it facilitates mechanical progress. 

Under frontier conditions, where each man must perform 
a wide variety of functions, some prove utter failures, wast- 
ing so much time turning irresolutely from task to task 
that they accomplish nothing. These same men might 
prove highly efficient workmen under different industrial 
conditions. If our frontier communities had kept detailed 
records, we should find that they contained many a man 
who would have made a good architect or engineer, many 
a woman who would have made an excellent modiste or 
teacher, but who proved hopeless failures in the environ- 
ment in which they were placed. Architecture and engi- 
neering, designing of costumes and teaching of children, 
were indeed functions not wholly neglected, but they made 
up a very small part in the life of each family and gave 
little opportunity to any one for the full development of 
his natural talents. 

Division of labor makes it possible for persons who have 
not the time or the versatility to learn how to perform a 
variety of functions to attain to a place of usefulness in 
industry. There are many persons who cannot afford the 
time to learn the tailor's trade ; many who have the time 



n6 INTRODUCTION TO ECONOMICS 

for apprenticeship, but not the general ability required for 
the making of a well-fitting coat. Few persons are so 
stupid that they cannot, with slight waste of time, learn 
how to sew a straight seam. If the work of making a coat 
is distributed among a dozen persons, each one can quickly 
learn to do well his particular part. Further, in the dis- 
tribution of the work, each one may be given a task pro- 
portioned to his ability. The skilled cutter will not waste 
his time picking basting threads, and the person for whom 
the latter function is a sufficient profession, will be kept 
from spoiling material through attempting something more 
ambitious. 

Perhaps the greatest advantage that arises from division 
of labor is the stimulus it gives to the invention of labor- 
saving machinery. A hundred years ago it would have 
seemed quite impossible to manufacture shoes largely by 
machinery. The process of manufacture appeared so com- 
plicated that hand labor alone would answer. To-day shoes 
are largely the product of machines. Many forces cooper- 
ated, of course, to bring about this result, but only one of 
these concerns us here, the division of labor. When a com- 
plicated operation like the making of a shoe is split up into 
several score of simpler operations, some of these are likely 
to prove so nearly mechanical that the idea of machines to 
take over the work suggests itself. If the process of pro- 
duction is divided into twenty-five parts, perhaps the third, 
and eleventh, and seventeenth are taken over by machines. 
In time division of labor still further simplifies the remain- 
ing operations; additional ones prove to be fitted for 
machine work, and thus more of the hand-workers are 
displaced. It is conceivable that in the end practically the 
whole process might be taken over by machines, while the 
hand-worker might be transformed into an attendant of the 
machine, so to speak, feeding it with material, and passing 
on the product to another machine. 



SPECIALIZATION OF ECONOMIC FUNCTIONS 117 

10. From a social point of view the division of labor is 
attended by serious drawbacks. 

The division of labor greatly increases the productive 
efficiency of the social working force, and this is from 
every point of view an advantage. It makes possible the 
utilization of many forms of labor that would otherwise 
find no place in the productive organization. This is an 
advantage when the form of labor utilized is incapable of 
development, as in the case of adults below the average 
in strength or in intelligence. Persons who would have 
to starve or beg under a system of complicated employ- 
ments are often able to earn a fair living under a system 
of simplified employments. 

On the other hand, the division of labor, and the accom- 
panying development of machinery, give inducement to 
the employment of classes that should not be employed 
at steady and monotonous labor. Small children and per- 
sons failing in health are drawn into the circle of sustained 
labor. The former should be allowed to develop their 
faculties in a natural way; the latter, to recover their 
health. When each employment required all the faculties 
of a normal man, there was nothing to tempt producers to 
employ laborers of this class. Since the introduction of 
division of labor, the evil of employing those who should 
not be employed has assumed serious proportions. Legis- 
lation has been invoked to limit the employment of chil- 
dren, but in few countries has child labor been subjected 
to wholly satisfactory regulation. 

Another serious disadvantage of the division of labor is 
that it tends to reduce the pleasure men derive from their 
work. The artisan who produces a completed piece of 
work usually takes an active interest in it. The carpenter 
takes pride in the houses he has built ; the cabinet maker, 
in the furniture that has come from his shop. It is a 
common thing to find men belonging to these trades — 



n8 INTRODUCTION TO ECONOMICS 

representatives of the earlier order — reluctantly leaving 
their work when the whistle blows or the foreman shouts 
" Time up." Not so with the workman whose day is 
spent in performing some minute part of the work of 
producing each one of a multitude of like commodities. 
His part in production is merged with that of his numerous 
fellows. He may, while young and enthusiastic, take pride 
in the achievements of the establishment where he is em- 
ployed ; but for the most part, his interest in the work is 
dependent on his prospect of receiving increased pay. 

A further disadvantage of division of labor is that it 
renders the workman dependent on a certain kind of work, 
and therefore exposes him to the risk of non-employment 
when supplies of material are wanting or when markets 
fail. There are in most modern countries many men and 
women who are well-trained textile workers, but who do 
not know how to find other employment when a crisis 
causes a contraction of the textile industry. The higher 
the degree of specialization, the more serious are the 
effects of changes in industrial conditions. 

11. Progress in the specialization of economic functions 
is subject to a law of diminishing returns. 

We may now consider how far the principle of division 
of labor modifies the operation of the principle of diminish- 
ing returns, described in the last chapter. According to 
the latter principle, an increase in the amount of labor 
employed in connection with a limited amount of capital 
gives a return which is not proportionate with the increase 
in labor. But what if the additional laborers give oppor- 
tunity for division of labor which had not before existed ? 
Suppose that a tailor's shop with a capital of $20,000 
formerly employed six men ; it now employs twelve men. 
Division of labor can be carried farther with twelve men ; 
hence is it not possible that the employment of the second 
six men will double the output of the shop ? This is quite 



SPECIALIZATION OF ECONOMIC FUNCTIONS 119 

possible. An additional six men will give occasion to still 
more systematic division of labor, and so may still further 
increase the efficiency of each man. And so with a fourth 
set of six men. But it is evident that one cannot go on 
indefinitely subdividing the work of making a coat. Even- 
tually a point will be reached where further subdivision of 
labor increases the efficiency of each laborer only slightly ; 
still further subdivision, even less ; finally a degree of sub- 
division will be found that will not pay. That is, the prin- 
ciple of division of labor is itself subject to diminishing 
returns. A practical illustration of this fact is to be found 
in the organization of the working force in many large 
establishments where much use is made of division of la- 
bor. The making of a complete article is not assigned to 
a single man ; nor is it assigned to all the men in the shop. 
Each article is assigned to a " team," among the members 
of which the successive manipulations of the material are 
distributed. The entire working force may contain scores 
of teams. Now, the size of each team indicates the limits 
of the profitable division of labor. If an enterpriser limits 
each team to sixty men, this is proof that in his opinion 
a team of seventy men would not show so large a product 
per man. 

We may grant that an increase in laborers employed in 
connection with a given capital may possibly result in an 
increase in product more than proportionate to the in- 
crease in labor. This may hold true until the number of 
laborers is sufficient to compose a team of maximum effi- 
ciency. If an additional team is engaged, without increase 
in capital, it is doubtful if returns will increase in pro- 
portion to the number of teams ; a third team will show a 
return less than that of the second, and so on until the 
point is reached where it does not pay to employ an addi- 
tional team. So far as the principle of division of labor is 
concerned, then, the only qualification to be made in the 



120 INTRODUCTION TO ECONOMICS 

law of diminishing returns is that when we assume that 
labor increases, we must assume that it increases by teams, 
not by individual men. 

12. Summary. 

In the course of economic evolution, one after another of 
the functions of the primitive family group has been taken 
over by persons who make a specialty of it. The develop- 
ment of exchange has been a condition and a cause of the 
tendency toward specialization. The differentiation of 
economic functions may rest with the assignment to each 
individual of a particular trade, or it may be carried so far 
as to subdivide the work of a single trade. In the former 
case we have what is known as differentiation of occupa- 
tions ; in the latter, division of labor. 

A high degree of division of labor presupposes a well 
developed commercial organization. Improvements in 
transportation increase the number of fields in which the 
principle may operate, as does also increase in the density 
of population. In a society in which production is carried 
on by employer-capitalists with hired factory workers divi- 
sion of labor can be carried much farther than in a society 
in which the laborer works on his own account. 

The productive power of society has been greatly in- 
creased by differentiation of functions. The subdivision of 
tasks makes it possible for each individual to find work 
commensurate with his capacity, and facilitates mechanical 
progress. On the other hand, it encourages employers to 
substitute child labor for the labor of men, and it destroys, 
in large measure, the pleasure that men find in their work. 

Up to a certain point progress in the division of labor 
neutralizes the effect of diminishing returns. But division 
of labor is itself subject to diminishing returns; the earlier 
stages in the process are more fruitful than the later ones. 



CHAPTER VIII 



THE CONCENTRATION OF INDUSTRY 

1. The average size of the business establishment is 
steadily increasing. 

It is a matter of common observation that to launch a 
business to-day a larger capital is required than was the 
case a generation ago. An examination of the census 
statistics of manufactures shows us how strongly marked 
this tendency toward larger establishments has become. 
From 1880 to 1905 the number of establishments mak- 
ing agricultural implements decreased from 1943 to 648, 
while the aggregate capital of the industry increased from 
$62,000,000 to $196,000,000. The following table illus- 
trates the same tendency in other industries : — 



- 


1880 


1880 


1905 


1905 




Number of 
Establishments 


Capital 


Number of 
Establishments 


Capital 


Boots and Shoes . 


4,959 


$42,000,000 


I,3l6 


$96,000,000 


Chemicals . . . 


595 


28,000,000 


448 


119,000,000 


Furniture . 


5,227 


44,000,000 


2,482 


152,000,000 


Iron and Steel 


1,005 


230,000,000 


605 


936,000,000 


Lumber .... 


25,758 


181,000,000 


19,127 


5 1 7,000,000 



In many other industries, while the number of establish- 
ments increased during this period, the capital increased far 
more rapidly. The number of establishments making cotton 
goods increased from 1005 to 1 1 54, but the capital increased 
from $219,000,000 to $613,000,000. Silk manufacturing 
establishments increased from 382 to 624; their aggregate 
capital increased from $19,000,000 to $109,000,000. There 



122 INTRODUCTION TO ECONOMICS 

is hardly a single branch of manufacture in which the 
average establishment has not increased in size very 
markedly. The same thing is true even in greater degree 
in the business of transportation, both by rail and by 
water. In retail and wholesale trade, in banking, and in 
insurance, we find the same general tendency toward an 
enlarging business unit. The present may therefore justly 
be characterized as an era of business concentration. 

In order to understand this tendency, we must acquaint 
ourselves (i) with the external conditions making large 
scale business possible, and (2) with the advantages that 
enable the large business enterprise to prevail in competi- 
tion with the smaller one. 

2. The size of a business is dependent upon the facilities 
for assembling razv material. 

Among the industries showing least tendency toward 
increase in the size of the individual establishment is that 
of canning and preserving fruits and vegetables. In 1880 
the average capital of an establishment engaged in this 
industry was $20,000; in 1905 it was $21,000. A cannery 
must depend for its material upon the products of a rela- 
tively small area, since fresh fruits and vegetables cannot 
be carried far without deterioration, except at great expense 
for packing and icing. The size of an establishment for 
the making of butter and cheese suffers under the same 
limitations. The same thing was formerly true of the 
slaughtering of cattle and swine; but in these industries 
a radical change has occurred in recent years. 

For an analogous reason no marked tendency toward 
concentration has appeared in agriculture. In that indus- 
try, an important element in success consists in keeping 
the dwelling place of the laborers so near to the fields that 
no great amount of time is wasted in going to and from 
the work. It is also essential that the barns and granaries 
be near enough to the fields to obviate excessively long 



THE CONCENTRATION OF INDUSTRY 123 

haulage of the products. It follows, then, that the num- 
ber of acres that may be managed from a common center 
is somewhat narrowly limited. An apparent exception to 
this rule is to be found in the great wheat farms of Cali- 
fornia, the Dakotas, and the Canadian Northwest. Here 
the land is level and free from stones and stumps of trees ; 
the natural fertility is great, and evenly distributed over 
large areas. Cultivation consists simply in plowing, sow- 
ing, and harvesting, and this can be done by aid of the 
highest type of agricultural machinery. As soon as the 
natural fertility of the soil is exhausted, however, a more 
intensive tillage will be necessary ; fertilizers will have 
to be applied; rotation of crops will succeed continuous 
wheat-cropping. For such tillage the immense unbroken 
fields are not well adapted. The "bonanza" farm is a 
transient as well as an exceptional phenomenon. 

3. The size of the business unit is further dependent upon 
the facilities for marketing prodticts. 

Some products deteriorate so rapidly that they cannot 
be produced in large masses and distributed over wide 
areas. Bakers' bread will serve as an example of this type 
of commodity. It would be useless to erect a bakery so 
large that it could not find a sufficient market for its wares 
within easy delivery distance. The production of many 
kinds of fresh fruits and vegetables is similarly dependent 
on a local clientele for a market, and the size of the estab- 
lishment is limited accordingly. Some products are limited 
to a narrow local market because they are too bulky to 
justify transportation over long distances. Common bricks 
and firewood fall in this class. In both classes, the denser 
the population, the larger the business establishment that 
can be successfully operated. 

4. Every improvement in transportation and reduction of 
charges makes possible an increase in the size of the average 
business establishment. 



124 INTRODUCTION TO ECONOMICS 

Reduction in the charges for carrying wheat and flour, 
both by rail and by water, have resulted in an extraordinary 
concentration of the business of grinding grain. The 
average flour and grist mill in 1880 had a capital of 
$7250; in 1905, the average capital was $26,500. In 
Minnesota, the chief center of the industry, the average 
capital is nearly $100,000. 

Low rates on stock cars, and the development of the 
refrigerator car and refrigerator storage on shipboard, 
have made possible the centralization of the slaughtering 
business. Reductions in the rates on furniture have 
enabled Michigan furniture makers to send their goods to 
the most distant parts of the United States. There is 
scarcely a single manufacturing enterprise in the United 
States which has not been brought within reach of a wider 
market by the recent progress in transportation. 

Mercantile establishments find their sphere enlarged in 
similar manner. Rapid transit for passengers, and the 
advent of the motor delivery wagon, have enabled many 
retail stores to expand far beyond the requirements of the 
territory they originally served. The adoption by the 
United States of a parcels post system similar to that of 
European countries, would enable many "mail order" 
stores to extend their business much beyond its present 
limits. 

5. Where industry is carried on by individual enterpris- 
ers, business concentration depends upon the concentration of 
wealth. 

Before the middle of the nineteenth century the typical 
business enterprise, both in the United States and in 
foreign countries, was owned by a single individual or by 
a partnership consisting of a small number of individuals. 
Large scale enterprise, then, was possible only where 
comparatively few had gained possession of large fortunes. 
In countries where there was little inequality in wealth, 



THE CONCENTRATION OF INDUSTRY 125 

as in France, the concentration of business could not be 
so marked as in countries where inequalities were greater, 
as in England. In the newer and more democratic parts 
of the United States, enterprise was conducted on a 
smaller scale than in the older parts, where wealth had 
been accumulated in fewer hands. 

6. The corporate form of business organization makes 
possible a higher degree of concentration than is possible 
under a system of individual enterprise. 

A business corporation, or joint stock company, is an 
association of individuals authorized by government to 
carry on an enterprise and endowed with certain special 
privileges, the most important of which is the right to be 
treated in law as a single person. Members of the asso- 
ciation are such by virtue of ownership of shares or stock 
in the corporation. In the simplest form of corporation 
all shares of stock represent equal shares in the control 
of the corporation and equal claims upon its profits. The 
stockholders elect a board of directors and other impor- 
tant officers; employees of minor rank are usually ap- 
pointed by the president, or by the president and directors. 
All business of the corporation is carried on by its officers 
and employees ; shareholders, as such, cannot engage in 
business in the name of the corporation. 

When a member of a non-corporate business association, 
or partnership, dies or withdraws from the business, it is 
necessary to wind up the affairs of the association. When 
a holder of stock in a corporation dies, his shares descend 
to his heirs, like any other personal property; when 
he wishes to withdraw from the corporation, he merely 
sells his shares. Changes in the personnel of the stock- 
holders do not affect the business of the corporation. 
Therein lies the great superiority of the corporation over 
partnership associations. The former, when not limited 
by law, has perpetual life, and can therefore undertake 



i 2 6 INTRODUCTION TO ECONOMICS 

policies looking to distant gains ; the partnership, on the 
other hand, is subject to dissolution at any time, and is 
therefore unsuited to large and permanent enterprises. 

Wherever the corporate form of organization is well 
established, large enterprises become possible even in 
communities where there are no individuals possessing 
great wealth. A steel plant requiring an investment of 
$6,000,000 may be erected in a city where no man has 
more than $10,000 to invest. Capital secured from a 
thousand different persons thus acquires the same effec- 
tiveness as a vast capital owned by a single individual. 

The corporate form of organization is to-day the pre- 
vailing form in the United States. Corporations produced 
73.7 per cent of the manufactures of the United States in 
the year 1905. Individual and partnership enterprises 
were indeed far more numerous than corporations, repre- 
senting 74.9 per cent of all enterprises. But the establish- 
ments thus organized are, as a rule, small ones, and are 
of dwindling importance in the nation's industry. 

Having gained an insight into the conditions under 
which business concentration is possible, we may proceed 
to a consideration of the advantages which the large es- 
tablishment enjoys. 

7. The large establishment can make the most extensive 
use of the principle of division of labor. 

As we saw in the last chapter, manifold advantages 
spring from the division of labor. The establishment to 
be launched must be at least large enough to make the 
fullest practicable use of this principle. Perhaps this end 
would be attained, so far as the working force directly 
engaged in the process of manufacture is concerned, in 
an establishment with a capital of $100,000 and with 100 
laborers. A second 100 laborers, supplied with an equal 
amount of capital, might double the output, but they 
would not increase the efficiency of the first hundred men. 



THE CONCENTRATION OF INDUSTRY 127 

So with a third and fourth hundred men. No further 
economy in concentration arises under this head. 

In addition to its manual laborers, the establishment 
must have an "office" force; possibly it may have buying 
agents, who travel long distances in search of the various 
materials, and selling agents, likewise compelled to travel 
about in search of buyers. A small establishment could 
support only a small number of employees of these 
classes; there could be no extended division of labor 
among them. An establishment of larger size might be 
able to assign one man exclusively to the purchase of one 
kind of material, another to the purchase of another kind, 
and so enjoy the advantages of specialized skill. Similar 
division of labor might be effected among the selling 
agents and among the members of the office force. In 
this way a very large establishment could assure itself 
that every commercial situation arising would receive ex- 
pert attention. There is, of course, no theoretical limit 
to the possible gains from this source. An establishment 
might be so large that it could have a man devoting his 
full time to the purchase of machine oil for its use, and 
something would doubtless be gained through the skill he 
would develop. But in practical life such trifling gains 
would have little effect in determining the size of an estab- 
lishment. They are too small to make a perceptible addi- 
tion to dividends. 

8. In the large establishment it is possible to make use 
of the most perfect mechanical equipment. 

The process of manufacture may involve a score or 
more of manipulations of the material, and at each stage 
several machines may be drawn into use. A number of 
different types of machinery are on the market, some per- 
forming the function required with greater celerity and 
certainty than others. The better machines, naturally, rep- 
resent a larger investment. To equip a factory throughout 



128 INTRODUCTION TO ECONOMICS 

with the best machinery would require a large capital, 
even if the process could be reduced to a series of steps 
occupying one set of machines as long as another. Such 
a division of the process is not ordinarily practicable ; some 
machines contribute only very slight changes in the material, 
delaying it but a moment as it passes through, while other 
machines subject the material to more important changes 
and delay it for a longer period. In order that the machines 
may all be used to their full capacity, there must be a num- 
ber of machines engaged in the slower parts of the process 
to one engaged in the part which can be performed quickly. 
And this involves a still further increase in the capital of 
the establishment. 

In most industries, the general progress of invention is 
in the direction of more costly machines, and this is one of 
the more important reasons for the trend toward industrial 
concentration. At a particular time, however, there is a 
theoretical size of business which permits full equipment 
with the best machines then available. An increase in the 
establishment beyond this point brings no advantage in 
the direct process of manufacture. There may, however, 
be other important advantages to be gained through such 
enlargement of plant. 

9. The large establishment enjoys the advantage of cheap 
power. 

The providing of power, in most manufacturing indus- 
tries, is one of the most important of technical problems, 
and here the large establishment usually has decided ad- 
vantages. The larger the power plant, in general, the 
cheaper can power be furnished. There is not so much 
heat wasted in a large furnace as in a small one ; a large 
power plant can be so arranged as to prevent much of the 
waste of power in transmission that usually takes place in 
a small establishment. Here it would be difficult to find a 
theoretical limit to the advantages that follow from an in- 



THE CONCENTRATION OF INDUSTRY 129 

crease in size of plant. In practice, however, the econo- 
mies to be gained in this way are not very important after 
a moderate size of plant has been reached. We do not 
find men constructing huge factories merely to obtain the 
advantages of cheaper power, although these advantages 
may not be entirely neglected in determining the size of a 
business to be established. 

10. The large establishment wastes less material than 
the small one. 

In the early history of the American iron industry the 
waste of fuel and metal was enormous. Present-day iron 
manufacturers find it worth while to resmelt the masses of 
slag left as worthless by the early smelters. The increase 
in the size of the blast furnace has reduced by over fifty per 
cent the amount of fuel necessary to produce a ton of pig 
iron. The wastefulness of small scale industry is strikingly 
illustrated in gold production. In one gold mining district 
of Mexico it is estimated that $120,000,000 worth of metal 
has gone down into the streams in the mud and sand from 
which the gold is washed. Modern large-scale methods 
would have recovered practically all of this gold. 

Furthermore, much material which would be absolutely 
useless to the small producer is made to yield a profit to 
the large enterprise which is adequately provided with 
equipment. On the Snake River in Oregon are large 
deposits of gold-bearing gravel, but the amount of gold 
contained in the gravel — about twenty cents per cubic 
yard — would not pay the small producer for the trouble 
of getting it. A gold-dredging enterprise has secured an 
enormous profit — in one year, 128 per cent on its capital 
— from this gold deposit. 

11. The large enterprise can often tttilize, for by-products, 
what the small enterprise rejects as waste. 

In almost every industry the material undergoes some 
shrinkage in the process of manufacture, through the 



130 INTRODUCTION TO ECONOMICS 

removal of parts not fitted to enter into the main product. 
These parts are waste in a small establishment, and the 
problem of getting rid of them is often a serious one. In 
the large establishment they accumulate in enormous 
quantities, and the question whether they could not be 
utilized in some way readily suggests itself. Through suc- 
cessive experiments, one element after another ceases to 
figure as waste, and is transformed into a by-product. 
Thus forty years ago much of the residue of the small oil 
refineries was allowed to flow away in the streams. The 
same material to-day is the basis of scores of by-products, 
the value of which is an important element in the profits 
of the petroleum industry. Compare the methods of waste 
disposal of the small butcher shops of to-day with those of 
the great packing houses. To the former from forty to 
sixty per cent of every animal slaughtered is sheer waste, 
to be got rid of in whatever way the public health authori- 
ties will permit. This waste in the large establishment is 
transformed into over a hundred by-products, practically 
no part of it being considered wholly valueless. Such 
utilization of waste requires the investment of a consider- 
able capital in various kinds of appliances and the employ- 
ment of a large body of laborers who have nothing to do 
with the main product. Some of the by-products take 
from the mass of waste only insignificant elements ; hence 
their utilization is possible only when waste accumulates 
in enormous quantities. It is obvious that only a very 
large establishment can carry on a thoroughly systematic 
plan of developing by-products. An establishment large 
enough to enjoy all the advantages of division of labor 
and of costly machinery may not be one tenth large 
enough to gain all the profits of waste utilization. 

12. The large establishment can secure materials at lower 
prices, and sell its products at higher prices, than is possible 
for the small establishment. 



THE CONCENTRATION OF INDUSTRY 131 

It has already been pointed out that an important ad- 
vantage of the large establishment is the possibility of or- 
ganizing its buying and selling agents in such a way as to 
develop special skill for each kind of transaction. A further 
commercial advantage consists in the fact that purchases 
can be made on a large scale, and therefore, generally, 
on especially favorable terms. The dealer in raw material 
can afford to sell at an unusually low price to a customer 
whose purchases may mount up into millions. The same 
thing is true of all other dealers who supply the large 
establishment. There may, indeed, be a combination 
among such dealers, fixing the margin of profit at which 
each must sell; but such a combination can do little toward 
extorting high profits from an enterpriser who can, if he 
chooses, dispense with the middleman altogether, and deal 
directly with the producer of the materials. The maker 
of machinery is likewise compelled to content himself with 
a small profit when dealing with a concern which has capi- 
tal and enterprise enough to make its own machinery, if 
it finds a profit in so doing. In its sales, the large es- 
tablishment enjoys similar advantages. It can provide 
each purchaser with such quantities and such qualities as 
he may desire. If part of the product is to be exported, 
the large establishment can afford to send agents to foreign 
countries to find out what qualities are desired, and in what 
form the product will be most acceptable to the foreign 
taste. 

The large enterpriser, further, can make a more sys- 
tematic study of the market than can the smaller one, and 
so can make his purchases and sales when the markets 
are most favorable. 

13. The large establishment often enjoys exceptionally low 
rates on its shipments. 

Since the large enterprise commonly secures its supplies, 
and ships its products, in large quantities, it can more 



132 



INTRODUCTION TO ECONOMICS 



frequently avail itself of the low rates on carload lots than 
can its smaller competitors. More important still, it can 
often force railway and steamship companies to discrimi- 
nate in its favor in fixing charges. Formerly this was 
done openly. When laws were passed forbidding discrimi- 
nating rates, the large enterprise was given secret rebates, 
which often represented a very material reduction in rates. 
This practice, it is believed, is not so common as it was 
some years ago. Whether this is true or not, there can be 
little doubt that in the past railway discriminations have 
played an important part in hastening the concentration 
of industry. 

14. The large enterprise usually pays a lower rate of 
interest on loans than the small enterprise. 

No matter how large the capital of an enterprise may 
be, there will at times be need of borrowing money. At a 
particular time the market for materials may be so favor- 
able that it will be profitable to purchase large supplies 
beyond current needs. An active business will not have 
on hand any large amount of idle cash ; hence the neces- 
sity for borrowing. As a rule, bankers lend money at a 
lower interest rate to a large enterpriser than to a small 
one. The principal reason why they do this is that the 
large establishment appears to offer better security than 
the small one. 

15. The advantages of business concentration vary in 
their nature from industry to industry. 

The foregoing is of course very far from an exhaustive 
statement of the advantages of the large enterprise as 
compared with the small one. Other advantages will 
readily occur to any one who observes the economic de- 
velopment of the locality in which he lives. It will be 
observed that some of the advantages are prominent in 
one industry, some in another. In the manufacture of 
cotton cloth, for example, there are no important by- 



THE CONCENTRATION OF INDUSTRY 133 

products to be utilized. The market for ordinary grades 
of cloth is well developed ; the jobber takes the product 
from the manufacturer's hands and disposes of it to the 
retailer, charging a commission so low that it would hardly- 
pay the manufacturer to develop selling agencies of his 
own. Neither the material nor the product is very bulky, 
in comparison with its value ; hence the advantages en- 
joyed by the large concern in the matter of freight trans- 
portation are not likely to be of very great importance. 
To equip a mill thoroughly with the best machinery in the 
market does not require a very large capital ; nor does an 
establishment have to be very large to enjoy to the full the 
advantages of division of labor. Certain advantages do 
indeed attend mere size, even in this industry ; but they 
are not so important that they may not be counterbalanced 
by slightly better management on the part of the smaller 
establishment. 

In the iron and steel industries, on the other hand, a 
complete equipment of machinery is usually very costly. 
A large capital is required to keep every important 
machine in constant use. The transportation of materials 
and products is expensive, and a great part of the profit of 
an establishment may depend upon the kind of contract 
that can be made with the transportation companies. By- 
products are not very important, but the larger establish- 
ment can secure large economies through making the 
best use of its material. Fuel is of course an immensely 
important item in the industry, and decided advantages 
are to be obtained through purchases on a large scale. 
Furthermore, the larger the establishment the greater the 
economy possible in the use of the fuel. Accordingly, in 
this industry a very large plant will have substantial 
advantages over one of moderate size. In the meat pack- 
ing industry, so far as the use of machinery is concerned, 
there is no important advantage enjoyed by the very large 



I 3 4 INTRODUCTION TO ECONOMICS 

plant of which a plant of moderate size could not avail 
itself. Economy of fuel is another minor consideration in 
this industry. The important advantages of the large 
plant consist in more systematic division of labor, better 
utilization of by-products, better conditions of transporta- 
tion, and more effective advertising. In the refining of 
petroleum almost every form of advantage that has been 
mentioned favors the large establishment. 

It is not to be inferred that the advantages of the large 
establishment are confined to manufacturing industry. 
Mercantile business shows much the same tendency to- 
ward concentration. In the retail trade, the large estab- 
lishment enjoys great advantages in the purchase and sale 
of goods; it not only buys more cheaply, but it is better 
able to cater to the tastes of its customers than the small 
store. It can afford a style of advertising that reaches the 
public, while the small establishment is likely to throw 
away the money it spends in advertising, not succeeding in 
impressing the conviction of its merits upon the prospective 
customer. 

16. The gains from concentration are subject to a law of 
diminishing returns. 

Theoretically it is difficult to establish a point beyond 
which further enlargement of a business establishment 
would be unprofitable. Every enlargement of a petroleum 
refinery, for example, makes possible some new economies. 
After a certain size has been reached, however, an estab- 
lishment is able to enjoy most of the known advantages of 
large scale production. In some industries, this involves 
an investment of $500,000 ; in other industries, perhaps, of 
$50,000,000. A capital of such size the enterpriser will 
vigorously strive to bring together. A profitable business 
may perhaps be conducted with a much smaller capital; 
but it will be more and more seriously handicapped as time 
passes, and the average size of new competing establish- 
ments increases. 



THE CONCENTRATION OF INDUSTRY 135 

There is of course no reason why an establishment 
should not be much larger than is necessary to obtain 
practically all the benefits of large scale production known 
at the time. Say that a $2,000,000 plant offers all these 
advantages, there is no reason why a $4,000,000 or a 
$6,000,000 plant should not be established. But capital 
cannot be got together without effort; and unless substan- 
tial advantages are to be gained through the larger in- 
vestment, the enterpriser is likely to rest content with the 
smaller one. 

As we have seen, the expansion of businesses already 
established, in whatever branch of industry, is confined to 
narrow limits by the law of diminishing returns. There is 
a similar law which confines within narrow limits the size 
of a new enterprise in an industry dependent upon local 
supplies of material, or a local market for its products. 
With such enterprises, a point is reached where increasing 
business is attended by increasing cost, transportation gen- 
erally representing the expanding element in cost. Finally, 
we have the new enterprises in industries which are prac- 
tically independent of local supplies of material and of the 
local demand for products. In these enterprises we may 
assume that no element in production is as yet fixed. 
They may, within limits, assume such magnitude as will 
give them command over all the economies of large scale 
production. These economies have a determining impor- 
tance in the choice between a small business and one of 
moderate size; they are of less importance in the choice 
between an establishment of moderate size and a large 
one; with further increase in size of establishment their 
importance dwindles. Perhaps there is no point at which 
further economies cease ; but there is a point at which they 
cease to be of practical importance. In economic lan- 
guage, the economies from concentration of industry are 
subject to a law of diminishing returns. 



136 INTRODUCTION TO ECONOMICS 

17. Summary. 

Concentration, or increase in size of the business estab- 
lishment, is a characteristic of the existing stage of eco- 
nomic development. A partial explanation of concentration 
is to be found in improvements in transportation, which 
make possible the assembling of raw material and the 
marketing of finished products. A prerequisite of con- 
centration is the control of great wealth by single enter- 
prisers. Such control may result either from the growth 
of large fortunes or from the adoption of the corporate 
form of business organization. 

The advantages of large-scale production are: (i) more 
thoroughly systematized division of labor; (2) better me- 
chanical equipment ; (3) cheaper power; (4) utilization of 
waste; (5) lower prices for materials and higher prices for 
finished products ; (6) lower charges for transportation ; 
(7) lower interest rates. All these advantages are subject 
to a law of diminishing returns. 



CHAPTER IX 
BUSINESS COMBINATIONS 

1. In many branches of trade and industry the several 
establishments are forming combinations that limit in greater 
or less degree the independence of action of each one. 

In the last chapter we saw that the average industrial 
establishment is steadily increasing in size. In some in- 
dustries concentration has already gone so far that a small 
number of establishments control the greater part of the 
output. A movement that is even more striking than 
the concentration of industry is the formation of combina- 
tions among the enterprisers controlling an industry. This 
movement is, in part, a direct result of concentration. 
When the number of producers becomes small, it is rela- 
tively a simple matter to unite them for a common purpose. 
The tendency toward combination is, however, not a neces- 
sary result of concentration ; we may therefore best treat 
the two movements separately. 

Combinations are most frequent in the fields of trans- 
portation and manufacture. Most of the railways of the 
country are combined in a few great systems ; most of the 
manufacture of steel is controlled by half a dozen great 
combinations, and the same thing is true of illuminating 
oil, tin plate, sugar, and a great variety of other industries. 
The production of copper and the smelting of silver and 
gold-bearing ores is largely controlled by combinations. A 
combination of great capitalists controls the mining of 
anthracite coal ; in some parts of the country the mining 
of bituminous coal has fallen under the domination of com- 
binations. Indeed, we may say that the tendency toward 

137 



138 INTRODUCTION TO ECONOMICS 

combination manifests itself in practically every branch of 
economic life. 

2. Combination may take the form of a union of pro- 
ducers that, as independent units, would be in active competi- 
tion with one another. 

The combinations that first attracted serious attention 
in the United States were organized in the field of railway 
transportation. Two roads, uniting the same terminals, in- 
stead of competing recklessly for business, often formed 
agreements dividing the traffic on what appeared to them 
an equitable basis. In most of the early industrial combi- 
nations, the members forming the union were engaged in 
the same stage of the process of production, and hence 
were active competitors until the combination was formed. 
Such were the steel rail, the tin plate, and the wire nail 
combinations in the iron and steel industries. Similar com- 
binations have existed among the paper manufacturers, the 
smelters of the more valuable metals, the distillers, and the 
binding twine manufacturers. It is associations of this 
kind that are commonly designated by the term combination. 

3. Combination may assume the form of a union betzveen 
establishments engaged in different stages in the process of 
producing and marketing a commodity. 

One of the earlier phases in economic development was 
the distribution of the various stages in the production of 
a commodity among a number of industries or sub-indus- 
tries. The manufacture of woolen cloth represented sev- 
eral independent industries: washing and sorting wool, 
carding and spinning, weaving, fulling, dyeing. The dis- 
tribution of the product to the various consuming centers 
gave rise to another independent line of business, the 
wholesale trade. The work of placing the finished product 
in the hands of the consumer was taken over by another 
business, the retail trade. 

In recent years an opposing tendency has made its 



BUSINESS COMBINATIONS 



1 39 



appearance. The entire work of preparing and distribu- 
ting a commodity is, in many cases, undertaken in a com- 
bination of establishments representing a single enterprise. 
One company mines coal and iron ore, transports these 
materials in its own ships and over its own railways, trans- 
forms the materials into pig iron for use in its own steel 
plant, and sells the finished product — rails, structural ma- 
terial, etc. — directly to the final purchaser. There are 
furniture makers that advertise the fact that every stage 
in the process of production, from the felling of the tree 
to delivery at the customer's door, is under their control. 
Shoe manufacturers own the tanneries that supply them 
with material, and chains of retail stores that place the 
product before the consumers. This uniting of all the 
stages in the process of production in one combined enter- 
prise is known as the integration of industry. Integration 
and combination in the restricted sense often go hand in 
hand. The United States Steel Corporation is a combina- 
tion of producers in the final stage in production, as well 
as a combination of producers in different stages of the 
process. 

4. Some combinations are temporary in their nature. 

Even in an industry which is apparently so unfavorable 
to combination as agriculture, temporary combination is 
becoming fairly common. Farmers often combine for the 
purchase of machinery, seed, or other supplies, or for the 
shipment of their products to distant markets. Similarly, 
petty retailers combine in the purchase of goods from the 
manufacturers, thereby gaining the benefits of purchasing 
in large quantities. A number of newspapers often unite 
in sending a correspondent to a war or other center of 
popular attention. Groups of financiers often form combi- 
nations, known as "syndicates," to subscribe a loan which 
would tax too seriously the resources of any one. Combi- 
nation of the nature here described is often termed business 



140 INTRODUCTION TO ECONOMICS 

cooperation. It is to be carefully distinguished from labor 
cooperation, a system under which the laborers seek to rid 
themselves of the control of an employer. 

Another form of temporary combination has for its pur- 
pose common action in fixing, prices. In the year 1908 
there was a widespread combination among cotton pro- 
ducers with the object of holding their cotton for a fixed 
price. Competing railways frequently agree upon charges 
for a limited period of time. Groups of speculators often 
combine to force up the prices of commodities or securities 
over which they hold a temporary control. 

5. Some combinations, though permanent in nature, in- 
clude in their scope only a small part of the activities of their 
several members. 

In many parts of the country the growers of fruit have 
formed associations for the purpose of controlling the 
marketing of products. In his business as a fruit grower, 
each member of the combination is entirely independent ; 
each member endeavors to excel his fellows in quantity 
and quality of output. Long experience of the exactions 
of the transportation companies and the commission mer- 
chants has led to united action in the marketing of products. 
Some of the larger associations have agents who visit all 
the important consuming centers and make the most favor- 
able terms with the merchants who deal with the consumer. 
They also have agents whose duty it is to watch over the 
movement of cars bearing the products of the association, 
and to take note of the condition of the products at the 
time of delivery. In some countries dairymen and poultry 
producers have organized similar associations. 

Most of the newspapers of the country are combined for 
the purpose of gathering news. This work has become 
so complex that a paper which cannot avail itself of the 
Associated Press dispatches has little chance of survival. 
In every large city the banks maintain a clearing house, 



BUSINESS COMBINATIONS 141 

where the claims of the various banks upon one another 
are settled. So important is this function of settlement 
that a bank which is excluded from the clearing house is 
seriously handicapped in its business. In some German 
industries the several establishments, while acting independ- 
ently in the domestic market, maintain common agencies 
to handle the export trade. 

In many cases in American industrial history attempts 
have been made to control by combination the aggregate 
output of an industry, and so to fix prices. The several 
enterprises were left free to pursue their own policies in 
matters of production ; in matters pertaining to the mar- 
keting of products they were subject to the control of the 
combination. This form we shall consider further in a 
later section. 

6. A combination may merge the several establishments 
into a single enterprise. This form of combination is known 
as a consolidation. 

In the great industrial enterprises of to-day, such as 
the United States Steel Corporation, the Standard Oil 
Company, and the American Sugar Refining Company, 
the separate establishments have completely surrendered 
their independence of action. Each establishment has its 
own officers, but these are chosen by the combination, or 
"parent" corporation, which thus determines their policy 
in every important respect. Several hundred combina- 
tions of this nature have been organized in the last ten 
years. So important are these combinations that many 
persons believe that the days of individual enterprise in 
the field of industry are numbered. 

7. The earliest effective form of permanent combination 
for purposes of price control was the "pool" an agreement 
distributing the amount of business to be done, or the receipts 
from the business, among the several enterprises. 

In the period following the Civil War competition be- 



142 INTRODUCTION TO ECONOMICS 

came so keen in many lines of business as to force prices 
to the cost level, or even lower. This was especially the 
case in railway transportation. At first an attempt was 
made to maintain rates through formal agreements ; but 
each railway, in its zeal for increased business, was strongly 
impelled to cut rates in spite of its agreement to maintain 
them. Various devices were employed to restrain this 
tendency toward cutting rates. The most successful of 
these were the "pools." A number of railways, com- 
peting for traffic between two centers, would agree upon a 
division of the traffic (" traffic pools ") or upon a division 
of the receipts from the traffic (" money pools "). Thus 
in 1870 the three railways connecting Chicago and Omaha 
made an agreement by the terms of which each road was 
to accept whatever through business was offered, at a rate 
set by mutual agreement. Each road was to retain for 
itself 45 per cent of the earnings of the through passenger 
business and 50 per cent of the earnings of the through 
freight business. The remainder of the earnings was to 
be placed in a fund to be shared equally by the three 
companies. This arrangement remained in force for prac- 
tically fourteen years ; it was finally destroyed by hostile 
legislation. 

A similar plan was adopted by the Bessemer Steel Pool 
in 1896. Each mill was assigned a certain percentage of 
the total amount of steel that was to be produced by the 
association. If any mill exceeded its allotment, it was re- 
quired to pay $2 a ton on the excess to the treasury of the 
association, and an equal sum was paid to those members 
of the association who fell short of their allotted output. 
In this way a restraint was placed upon the more active 
producers, and prices were maintained at a decidedly 
profitable level. This pool, like the great majority that 
have been formed, was short-lived. Some of the more 
powerful members became dissatisfied with the percentage 



BUSINESS COMBINATIONS 143 

of output allotted to them and withdrew, leaving the pool 
too weak to maintain prices. 

8. A stronger form of combination was created by placing 
a majority of the shares of stock in each constituent company 
permanently in the hands of trustees. This form of com- 
bination is known as the trust. 

In 1882 the stockholders of the leading petroleum refin- 
ing corporations, which had for many years operated in har- 
mony under informal agreements, placed a majority of 
their stocks in the hands of nine trustees. For the stock 
surrendered to the trustees, the owners received certificates 
entitling them to a share in the profits of the combination. 
The power to vote the stock was transferred irrevocably 
to the trustees, who were thus in a position to determine 
the policy of each company. This form of organization 
was adopted by several other powerful combinations. By 
a federal law of 1890, known generally as the Sherman 
Anti-Trust Law, the trust was made illegal, so far as it 
affected interstate commerce, and most of the states have 
passed laws prohibiting trusts. This form of combination, 
therefore, has been destroyed. 

9. A permanent combination may be established through 
the formation of a corporation for the purpose of securing 
control of a majority of the stock in each of the companies 
which it is sought to combine. Such a corporation is prop- 
erly termed a holding company ; in popular speech it is 
called a "trust." 

When the trust form of organization became outlawed, 
men who sought to attain the same end hit upon the de- 
vice of organizing a corporation with power to purchase 
and hold the stocks of other companies. The laws of 
several states, especially those of New Jersey, are very 
favorable to this form of organization. Accordingly, when 
a group of powerful producers desire to form a permanent 
combination, they secure a charter, we will say from the 



144 INTRODUCTION TO ECONOMICS 

state of New Jersey, authorizing the formation of a cor- 
poration with extensive powers, including the essential one 
of holding stocks in other companies. They then ex- 
change their shares in the business corporations which 
they control for shares in the new company, and endeavor 
to induce other persons interested in the same industry to 
do likewise. Or the new corporation may place its shares 
on the market, and use the proceeds in the purchase of 
shares of producing companies. In this way it is possible 
to bring a large part of an industry under a single control. 
The process of thus merging a number of enterprises into 
one is known as " consolidation." 

The so-called trusts of to-day are organized in the way 
described above. In some cases the holding company, in- 
stead of buying shares in a producing company, buys its 
plant outright. In many cases it fails to secure a majority 
of the stock in such a company, but secures a sufficiently 
large minority of stock to make its influence decidedly felt. 

10. Consolidation increases the productive efficiency of the 
several establishments. 

Where a number of establishments are competing, it is 
to the interest of each to retain exclusive possession of 
such improvements in methods as it may succeed in mak- 
ing. If an improvement consists in a mechanical inven- 
tion that can be patented, the establishment which secures 
it is protected in its monopoly by the law. It is conceiv- 
able that each one of a score of competing companies may 
thus retain exclusive possession of a device that the others 
could use to advantage. Consolidation permits each com- 
pany to make use of all the patented devices originating 
in the establishments of the other companies. 

The United States Steel Corporation is at present erect- 
ing, at Gary, Indiana, a steel-making plant which is to em- 
body every idea that has proved profitable in any of the 
plants of the company. It is anticipated that steel will 



BUSINESS COMBINATIONS 145 

be manufactured more cheaply at the Gary plant than is 
possible in any existing steel works. No company not 
having the combined experience of the Steel Corporation 
could hope to establish a plant of equal efficiency. 

The manager of one out of a number of competing 
establishments knows only in a general way what success 
his rivals are enjoying. One establishment may produce 
steel at slightly less cost than another, without attracting 
special attention. When one plant in a great combination 
shows a lower cost per unit of output than do the others, 
the fact is at once known to the officers of the combina- 
tion, who naturally seek to learn the causes of this supe- 
rior efficiency, in order to introduce improvements in the 
establishments of less efficiency. Thus in a consolidated 
enterprise there is a resistless tendency to force every 
establishment to keep pace with the one which displays 
the greatest efficiency. 

11. Consolidation encourages a higher degree of speciali- 
zation in production than does the system of competitive 
enterprise. 

An independent establishment, in order to retain its 
customers, is often compelled to cover a comparatively 
wide range of production. This involves keeping on hand 
a large amount of machinery which can be used only for 
a small part of the time. It also involves, in many cases, 
the production of goods for which the supplies of mate- 
rial upon which it relies are not especially well adapted. 
A consolidated corporation can send orders received to 
those plants which are in the best position to execute 
them promptly and efficiently. 

12. Consolidation makes possible the supplying of each 
customer from the plant nearest to him, and thus reduces 
cost of shipment. 

Where an industry is competitively organized, there is 
a tendency for each producer to invade the territory nat- 



146 INTRODUCTION TO ECONOMICS 

urally belonging to his competitors. Castings for use in 
Alabama should naturally be made in Alabama ; castings 
for use in the Pittsburg district should naturally be made 
there. But if there is competition between makers of 
castings in the two centers, some of the products of Pitts- 
burg will be sent to Alabama, and vice versa. This is 
sheer waste, and consolidation puts a stop to it, to the 
advantage of the producer and of society as well. 

It is true that under the competitive regime informal 
agreements among producers to respect one another's ter- 
ritory kept this form of waste within bounds. But there 
was always disputed territory, in which freights were use- 
lessly carried back and forth. Consolidation has elimi- 
nated cross freights, except in cases where real differences 
in quality make supplying from a distant mill necessary, 
or where the nearest mill is temporarily overwhelmed with 
orders. 

13. Consolidation reduces the chances of loss from over- 
supply or undersupply of the market. 

When an industry is carried on by a large number of 
competing employers, each one is in greater or less un- 
certainty as to whether he can market his products at 
remunerative prices. The causes for uncertainty are first, 
possible changes in the demand, over which the industry 
has no control, and second, changes in the combined out- 
put of the competing establishments. When a consolida- 
tion is formed, the second of these causes is eliminated. 
The producer knows exactly how great a volume will be 
placed upon the market. There is consequently less 
chance that great stocks will accumulate at a time when 
the demand is slack. When the volume of orders in- 
creases, the full extent of the increase is readily calcu- 
lated, and preparations may be made for a correspondingly 
greater output, if an industry is consolidated. If an indus- 
try is not consolidated, each producer, although receiving 



BUSINESS COMBINATIONS 147 

an increased volume of orders, is uncertain whether the 
expansion of the business is general or not, and so delays 
preparations for increase of output, with the result that at 
the height of business expansion he must turn away orders 
at profitable prices. 

Herein lies one of the chief advantages of the form of 
consolidation which we have described as industrial inte- 
gration. When the steel industry was competitively organ- 
ized, there was at one time overproduction of ore, at another 
time overproduction of pig iron, at still another time over- 
production of steel billets, even when there was no over- 
production in the final stages of the industry. Under 
present circumstances all stages in the industry keep pace 
with one another. If the demand for finished products 
appears to be on the increase, a symmetrical increase is 
ordered in the production of ore, pig iron, crude steel, and 
finished products. 

14. Consolidation reduces the expenses incidental to the 
marketing of products. 

The marketing of products is, in many lines of industry, 
a very complicated process, requiring great expense for 
advertising and for the services of trained salesmen. A 
manufacturer must often make special concessions in prices 
or in conditions of payment in order to introduce his goods ; 
under competition he is always in danger of losing custom 
because of the efforts of his rivals to introduce their goods. 
Some efforts are of course necessary under the most 
favorable conditions to attract the attention of purchasers. 
But it is manifestly a more difficult problem to attract the 
attention of purchasers away from a rival's wares than to 
attract their attention to the general class of goods. Con- 
solidation results in important economies in this respect. 
The Distilling Company of America is said to have saved 
$1,000,000 a year through reduction in the number of trav- 
eling salesmen, made possible by combination. In many 



148 INTRODUCTION TO ECONOMICS 

cases consolidated companies have been able to dispense 
with the traveling salesman, since purchasers, having no 
choice, are compelled to resort directly to the producer. 

One of the more important sources of loss to the com- 
petitive producer was the failure of purchasers to pay for 
goods secured on credit. The producer could not refuse 
credit, since by doing so he was likely to lose customers. 
The consolidated company can safely insist upon cash pay- 
ment, since it has few competitors to take its customers 
away from it. 

15. The consolidation can usually borrow money on more 
favorable terms than any one of a number of competing 
producers. 

As a result of the manifold advantages of the consoli- 
dated company, the chances of its failure are reduced to a 
minimum. If it is conservatively managed, loans made 
to it possess a high degree of security, and consequently 
bear a low rate of interest. Moreover, the mere fact that 
the consolidation represents a vast aggregate of capital 
places it in an extremely favorable position in the loan 
market. Every one has heard of the Standard Oil Com- 
pany, the United States Steel Corporation, the Harvester 
Trust, the great packing companies. Every one has 
formed an estimate of the financial standing of these com- 
panies. Consequently the man who has loaned capital to 
one of these companies can easily sell his claim upon it 
whenever he desires to regain possession of his funds. A 
small refinery or slaughtering establishment may hold a 
position that is financially as sound as that of one of the 
great companies mentioned. But this fact is not generally 
known, and those who loan money to the lesser companies 
find far greater difficulty in disposing of their claims when 
they desire to do so. For this reason they demand a higher 
rate of interest than they would be willing to accept from 
the great consolidation. 



BUSINESS COMBINATIONS 149 

16. The most important advantage arising from consoli- 
dation is the control over prices that it makes possible. 

All the advantages that have been enumerated would 
probably have been insufficient to cause an extensive 
movement in the direction of consolidation. Most of them 
could have been secured through a form of combination 
that would leave the independence of the individual estab- 
lishment practically unimpaired. Combinations of inde- 
pendent establishments for purposes of price control are, 
under the American system, opposed to the spirit of the 
law, and for this reason could not be satisfactorily main- 
tained. In Germany, where such combinations are recog- 
nized by law, there has been no tendency toward complete 
consolidation such as we have in America. 

It is still a disputed question whether consolidation 
has resulted generally in a material advance in prices. 
There are a number of cases in which it can readily be 
shown that these vast combinations have taken advantage 
of their monopolistic position to maintain prices at a level 
considerably above the competitive level. In other cases, 
consolidation appears rather to steady prices, preventing 
very low and very high prices, than to raise the average 
level. In any case, the rise in prices due to consolidations 
has been far less than a consideration of the monopoly 
position of these aggregations of capital would lead one to 
expect. The checks upon monopoly power, described in 
Chapter IV, appear therefore to be very effective. 

17. Summary. 

There is at present a tendency toward the formation of 
combinations of business establishments. The term com- 
bination is properly applied to unions between establish- 
ments in the same stage in the production of a commodity 
or service; it is, however, also applied to unions of estab- 
lishments in successive stages in the production of a com- 
modity. The latter form of combination is also termed 



150 INTRODUCTION TO ECONOMICS 

industrial integration. Combinations may be temporary or 
permanent, partial or complete. The permanent and com- 
plete combination is known as a consolidation. 

The chief forms of combination have been the pool, the 
trust and the holding company. The pool and the trust 
have been outlawed; existing combinations, commonly 
called "trusts," are of the holding company type. The 
holding company is a corporation which holds the stock of 
companies that are consolidated, and so controls their 
policy. 

The advantages of consolidation are (i) the increased 
technical efficiency of each establishment, through appli- 
cation of methods developed in other establishments; 

(2) greater opportunity for the specialization of each estab- 
lishment to particular grades of the commodity produced ; 

(3) reduction in transportation charges; (4) avoidance of 
oversupply and undersupply; (5) reduction in cost of 
marketing; (6) reduction in interest charges; (7) control 
of prices. 



CHAPTER X 
COMPETITIVE WAGES 

1. Labor is the application of human faculties to the pro- 
duction of wealth. 

We have found frequent occasion in earlier chapters to 
touch upon wages and interest. Wages and interest are 
parts of the cost of production of commodities, as we saw 
in Chapter V, and as such have an important part to play 
in determining values. In the present and the following 
chapters we shall endeavor to ascertain the laws deter- 
mining the rates of wages, interest, and whatever other 
forms of social income may remain after the shares of the 
laborer and of the capitalist are paid. In other words, we 
are entering upon a study of the distribution of wealth, 
or, more properly, of the distribution of the social income. 

Every expenditure of human energy having for its chief 
purpose the production or the preservation of economic 
goods, or the increase in the valuable qualities of existing 
goods, is labor, in the economic sense of the term. Labor 
includes not only the exertions of the manual workers, by 
whom actual changes in material commodities are wrought, 
but also the exertions of the foremen, superintendents, 
managers, under whose direction the manual tasks are 
performed. It includes the activities of police, of judge, 
and of legislature, upon whose efficient performance rest 
the possibility of continued production in most of the exist- 
ing branches of industry. Labor does not include, how- 
ever, efforts undertaken for their own sake, without regard 
to economic result. The amateur football team spends an 
immense amount of energy, and gets its reward in the 

151 



152 INTRODUCTION TO ECONOMICS 

spending. The amateur hunter often cares little or noth- 
ing for the birds he brings down; his reward is the gratifi- 
cation of the prehistoric thirst for blood. The professional 
football player and the professional hunter, on the other 
hand, are laborers. If any one thinks that this is a dis- 
tinction without a difference, let him ask the football 
amateur what claim to superiority he enjoys over the 
"professional"; let him ask the sportsman wherein the 
latter differs from the pot-hunter. 

2. Wages are the income received on account of labor per- 
formed. 

As the term " wages" is generally used, it signifies the 
money or other things of value paid by an employer to those 
who serve him in capacities of inferior dignity ; employees 
of higher rank receive "salaries." Political economy does 
not recognize any such distinction as this, based as it is upon 
the pretended social status of the recipient, rather than upon 
a difference of economic function. The ten cents a day paid 
to a child slave and the $100,000 a year paid to the presi- 
dent of an insurance company are alike wages in the blunt 
speech of the economist. Moreover, in economic language, 
the term " wages " extends to part of the income of a 
workman wfro is his own employer. One peanut vender 
may be working for a push-cart enterpriser, receiving a 
dollar a day for his efforts. This sum, all will agree, is 
nothing but wages. At the opposite corner of the square 
you may find another peanut vender, who is his own em- 
ployer. The latter may gain, over and above the cost of 
raw nuts, gasolene, push-cart hire, etc., just a dollar a day. 
The two men then receive equal rewards for identical 
services. Possibly the second vender calls his income 
"profits." Political economy cannot afford to use two 
different terms to designate essentially the same thing, 
especially when one of the terms, " profits," has a very 
definite meaning of its own. Whatever a man receives 



COMPETITIVE WAGES 153 

simply as a reward for his exertions, whether directly or 
through the intermediation of an employer, is wages. 

3. Contract wages involve more important economic prob- 
lems than does the wage income of the independent work- 
man. 

While we cannot properly exclude from the term wages 
so much of the income of an independent workman as 
arises from his personal exertion, we are nevertheless 
justified in devoting our attention almost exclusively to 
wages as determined by contract between employer and 
employee. An increasing proportion of the world's work 
is being done under this system, and most of the impor- 
tant economic problems of the day are concerned with it. 
Who ever heard of a "labor problem" in an agricultural 
community where every farmer relies exclusively on his 
own two hands ? In such a community, what importance 
attaches to the general movement of wages, whether up- 
ward or downward ? Indeed, who can determine, in such 
a society, how much of the total income of each farmer is 
wages, how much interest on capital invested in the farm ? 
Wages have existed ever since our first ancestors were 
condemned to eat their bread in the sweat of their brows ; 
but it is only under modern conditions, where one man 
pays another to work for him, that it comes to be of great 
importance to ascertain what laws govern the rate of 
wages. We shall therefore confine our study to that part 
of the economic field in which differentiation between 
employer and employee has taken place — where the 
"wage system" exists — and shall endeavor to ascertain 
the laws operative therein. These laws, indeed, exert an 
influence in the rest of the economic field as well, and are 
in turn influenced by forces lying outside of the field in 
which the wage system prevails. What a man could get 
as his own employer helps to determine how much he 
must have as a mere wage-earner ; what he could get as a 



154 INTRODUCTION TO ECONOMICS 

mere wage-earner helps to determine what he must gain 
as an independent workman. 

4. The returns resulting from the employment of a given 
amount of labor vary according to the conditions under which 
labor is employed. 

Let us set before ourselves, in imagination, an agricul- 
tural community in which all the land is owned by a small 
class of men who do not themselves engage in tillage, but 
hire the landless population to work upon their fields. And 
let us further assume that this population is unable or un- 
willing to migrate to other communities in search of em- 
ployment. Whether there are many workmen or few, they 
must all seek employment upon the land, or starve. 

Some of the land in the community is fertile, some of it 
barren. Some of it requires a large expenditure of labor 
for every bushel of wheat or potatoes produced ; some of 
it yields rich crops with little labor. Every good field 
yields a moderate crop with a small expenditure of labor ; 
if a larger crop is sought, it must be at the expense of a 
disproportionately large application of labor, as we saw in 
the chapter on Diminishing Returns. 

Accordingly, we may safely lay down the proposition 
that the results arising from the application of labor to dif- 
ferent fields, and in different methods of cultivation, will 
be unequal. Good land, in extensive cultivation, may yield 
three bushels of wheat per day's labor expended, while 
poorer land yields, perhaps, two bushels, and yet poorer 
land one bushel. Adding one day's labor to the amount 
previously spent on a piece of the best land may add only 
two bushels to the product, and adding still another day's 
labor may add only one bushel. 

5. Equal wages for equal tasks is the rule of competitive 
industry. 

However unequal the results of labor on different fields 
and under different methods of cultivation, the reward of 



COMPETITIVE WAGES 155 

labor — wages — will tend to be uniform, allowance made, 
of course, for differences in the physical efficiency of dif- 
ferent laborers. Suppose that a farmer has ten fields, of 
different degrees of fertility, and employs one man to cul- 
tivate each, the work on the different fields being uni- 
formly arduous. He would be a very unusual employer 
if he should propose to pay the men different rates of 
wages, according to the fertility of the field upon which 
each is employed. The probable result of such a plan 
would be that competition would arise among the men to 
win the employer's favor, each one desiring to be employed 
on the best field; and in the end we should probably find 
that the better fields would be apportioned to the men who 
would agree to perform for the employer various miscel- 
laneous services which would, generally speaking, be equal 
in value to the advantages they enjoyed in the way of 
higher remuneration. How this would work out we might 
consider at greater length if we did not know by experi- 
ence that even the most liberal employer is averse to grad- 
ing the wages of his men, not on a basis of their skill and 
faithfulness, but on a basis of the facilities for work which 
the employer himself furnishes. Cases of unequal rewards 
for the performance of equal' tasks are of course to be 
found ; but for these cases the explanation, as we shall see 
later, is of a wholly different nature. 

Just as uniform wages will be paid for like tasks by any 
one employer, so uniform wages will be paid by all the em- 
ployers in the community. No employer can keep in busi- 
ness unless he pays as good wages as any other. If any 
one raises wages slightly, he will attract to himself an in- 
creasing number of workmen, and he will soon get all he 
cares to have. In an earlier chapter we saw that there 
cannot be different prices for the same commodity in the 
same market. This law holds good for labor as for any- 
thing else one buys or sells. 



156 INTRODUCTION TO ECONOMICS 

6. The wages of any one of a number of laborers of equal 
efficiency will not exceed the addition to product made by the 
laborer whose sendees are least important to the employer. 

Of ten fields, the best one, when cultivated by one work- 
man, may yield a product worth $500; the worst one may 
yield only $1 50. What will be the maximum wage that the 
employer will pay ? Not more than $1 50. For he will not 
pay any workman more than the entire product created by 
the aid of that workman, and he will not, of his own volition, 
pay one workman more than another. Nor can any work- 
man compel the employer to pay him more than the one on 
the worst field receives. Suppose that the one employed 
on the best field insisted on a wage of $200. The employer 
would dismiss him, and place on that field the laborer 
formerly employed on the worst field. And so with any 
one of the ten laborers. What the employer would lose, if 
any one of them should " strike," would be simply the 
product of the worst field — $1 50, according to our premises. 

If we assume that the ten fields are owned by different 
men, we arrive at an identical result. The employer who 
owns the poorest field cannot possibly pay more than $150 
to the workman who tills it. If a workman on a better field 
demands more, his employer will dismiss him, and put in his 
place the workman formerly employed on the poorest field, 
whom he can easily induce to change employers by offering 
him a trifle more than the owner of the poorest field is able 
to pay. The dismissed workman must live ; probably he 
will have to seek employment on the abandoned field, and 
content himself with the wages that the owner of that field 
can pay. 

If we assume, instead of ten fields of varying fertility, 
one large, fertile field, giving employment to ten men, we 
see exactly the same principle at work. One of the men, 
cultivating the land extensively, may produce $500; a 
second may add to this product $450 ; a tenth may add to 



COMPETITIVE WAGES 157 

the total product of the nine previously employed only 
$150. The employer will not pay the first $500, the sec- 
ond $450, and so on down to $150. He will pay each one 
not more than $150. If any one should demand more, he 
would be dismissed, and his functions performed equally 
well by the man who otherwise would have added only 
$150. What the employer loses, when he loses any man 
of the ten, is the product created by the least important 
one of them all. 

7. The wages of any one of a number of laborers of equal 
efficiency cannot, under competition, be permanently less than 
the marginal product of labor, or the addition to product 
made by the laborer whose services are of least importance 
to his employer. 

We have, then, an upper limit of wages above which an 
employer cannot be compelled to go : the addition to the 
total output created by the man who works at the greatest 
disadvantage. Is there, similarly, a lower limit? In the 
situation we have assumed — a number of competing em- 
ployers, each able to increase his employment of men 
through breaking up new, though less fertile, lands, or 
through more intensive tillage of lands already under cul- 
tivation — it is unlikely that any employer will make a large 
net return on the last man he employs. Let us assume that 
the uniform yearly rate of wages is $120, while the product 
of the least important man varies from $120 on the least 
fertile farms to $175 on the most fertile ones. The man 
who has a fertile farm can increase his net income by offer- 
ing a little more than $120 for an additional workman. 
Such a workman will not add $175 to the total output — 
the law of diminishing returns forbids this — but he may 
add $170. As the employer on the least fertile field secures 
a product of only $120 from his last man, he is compelled 
to let a man go. Perhaps the man who now becomes 
his least important hand is worth $125 to him, and $125 



158 INTRODUCTION TO ECONOMICS 

may be what the man on the next better field is worth. It 
still pays the farmer with the best fields to seek additional 
hands. The wage he must now offer is more than $125, — 
let us say, $130. And the additional men will be worth 
less to him — perhaps $165 each. Competition will still go 
on between the employers having the better fields and 
those having fields that are not so good, each rise in wages 
affecting, of course, the wages of all the workmen in the 
community. At last a point is reached where no employer 
can take a workman away from his competitor without 
offering a wage so high as to outweigh the advantages 
to be derived from an additional employee. Here, then, 
wages will tend to remain stationary. Each employer will 
be paying his least important man so much that any in- 
crease in wages would make that man an unprofitable 
member of his working force. No employer would care 
to take on an additional man at the existing rate of wages. 
This means that on every farm the least important work- 
man adds to the total product only enough to cover his 
wages. The addition to product made by the man working 
under the least favorable circumstances is, then, not only 
the maximum that the employer can be compelled to pay ; 
it is also the minimum which he cannot avoid paying. If 
we describe as the "product of labor," that amount of 
valuable product which is brought into being by the pres- 
ence of any particular laborer, we may say that, under com- 
petition, wages are determined by the product of the laborer 
working under the least advantageous circumstances (in this 
case, on the poorest land). This laborer is known in eco- 
nomics as the marginal laborer, as he is on the " margin " 
or fringe of employment, as it were — in a position where 
his continued employment is almost a matter of indifference 
to the employer, since his presence means neither profit 
nor loss. In the customary economic formula, wages, un- 
der competitive conditions, are determined by the marginal 



COMPETITIVE WAGES 159 

productivity of labor (i.e. the productivity of the marginal 
workman). 

8. An increase in the personal efficiency of labor tends to 
raise wages. 

Let us suppose that in the course of time the working 
force of our assumed community becomes more efficient, 
either through increased intelligence or through improve- 
ment in skill or in physical strength. This might well be 
the case if the community is a comparatively new one, with 
a population imperfectly adjusted to its environment. It 
would then be quite possible that the product of the men 
working under the least favorable conditions would in- 
crease, let us say, by ten per cent. Wages under competi- 
tion would also increase by ten per cent. 

Many causes besides changes in the personal efficiency 
of labor are operative in raising or lowering the level of 
wages. But it cannot be doubted that the extremely low 
wages paid in such countries as India are in large measure 
due to the low average efficiency of the laboring class. 
The high wages paid in America are in part accounted 
for by the fact that American conditions spur the work- 
man to an activity surpassing that of workmen in other 
countries. It has often been noted that immigrants from 
European countries work much harder than they did in 
their native lands. 

9. An increase in the number of workers tends to reduce 
marginal productivity and wages. 

Now let us assume that the number of workmen in the 
community is increased by the immigration of equally ef- 
ficient workmen from another part of the country. The 
new men must have employment ; and there is of course 
plenty of work in the community for them to do — on one 
condition, however. They must accept employment on 
fields yet poorer than any now cultivated, or they must 
be added to the force at work upon the better land, occu- 



160 INTRODUCTION TO ECONOMICS 

pying themselves with tasks that formerly were neglected. 
In either case they will add less to the product than was 
created by the marginal workman before the arrival of the 
new hands. They must accept a rate of pay lower than 
that which formerly prevailed, else no employer could 
afford to hire them. And as there will not be two rates of 
wages for equally efficient men, the general rate for all 
the workmen originally employed in the community must 
be reduced. If the immigration continues steadily, other 
things remaining the same, the marginal product of labor, 
and with it the rate of wages, must steadily sink. 

If, on the other hand, some of the original landless popu- 
lation should move away, some of the worst fields would 
be abandoned, and it would become impossible to cultivate 
the better fields as intensively as before. On each field 
the importance of the marginal man would increase. 
If any employer should persist in paying the old rate 
of wages, his competitors, by offering a little more, would 
entice his men away. The tendency for wages to rise, 
with decline in the laboring population, would be as irre- 
sistible as the tendency for wages to fall with an increase 
in population. * 

10. Improvements in methods of production tend, as a rule, 
to raise wages. 

Let us suppose that in this community are found exten- 
sive tracts of marshy land of practically no economic 
importance. A competent engineer enters the commu- 
nity, and at a comparatively low expense drains these 
lands and transforms them into the very best quality 
of tillable soil. The owners of the drained lands must 
have labor, and can bid a higher price than prevails 
generally. If the laboring population remains stationary, 
the effect of the new demand for labor is to withdraw men 
from the least favorable situations and place them upon 
the new land. On every farm the product of the marginal 



COMPETITIVE WAGES 161 

workman is increased, and wages rise accordingly. If 
immigration of laborers is going on, the new demand for 
labor counteracts the effect upon wages of the new supply ; 
if emigration is taking place, the rise in wages that would 
otherwise occur is emphasized. 

A similar influence may be exerted by a general im- 
provement in agricultural practice. It is said that by the 
use of seed corn which has been grown in an isolated field 
from which all barren stalks have been removed before 
maturity, the average yield of corn may be increased from 
ten to thirty per cent. This increased yield is obtained 
without additional labor, excepting a small amount entailed 
by the care of the seed corn field. The use of such seed 
corn in the community we are studying would increase the 
product' of every laborer, that of the marginal ones as well 
as that of the rest, and the competition of employers with 
one another would force them to raise wages in the meas- 
ure of the increased marginal productivity. The intro- 
duction of a new forage plant, like Kaffir corn or alfalfa, 
might have a similar effect in increasing the productivity 
of the marginal laborers. So also might the use of a new 
kind of fertilizer, or the invention of a new agricultural 
implement. Almost all agricultural improvements, in fact, 
are likely to have the effect of increasing the productivity 
of labor and the rate of wages. 

It is not in the least necessary that such improvements 
find general application. An improvement increasing the 
productivity of labor on one tenth of the farms will gener- 
ally lead to an increased demand for labor on those farms. 
The demand is met by the withdrawal of labor from the 
farms not affected by the improvement ; and this results 
in raising the productivity of the least favorably situated 
laborers on those farms, and so raises general wages. 

11. A reduction in the rate of interest tends to raise 
wages. 



i62 INTRODUCTION TO ECONOMICS 

One other influence needs to be noted here ; namely, a 
fall in the rate of interest. There are few farms that could 
not be made to yield a much larger product, if abundance 
of auxiliary capital were to be had at a low rate of interest. 
If a farmer must pay ten per cent on borrowed capital, he 
cannot build a good barn or drain a marsh until he has 
accumulated a considerable amount of capital of his own. 
In the meantime opportunities for labor which would be 
thrown open if capital were to be had at five per cent lie 
untouched, and the existing labor supply is spread over 
barren fields, with consequent low productivity. Every 
reduction in the interest rate creates a new demand for 
labor, and withdraws part of the existing supply from the 
poorer fields, thus increasing marginal productivity and 
wages. 

12. In a complex industrial society \ laborers fall into many 
classes between which there is no direct competition. 

We may now sum up the results of our study of wages 
under the assumed conditions. Wages are determined by 
the marginal productivity of labor, but marginal produc- 
tivity itself is subject to many and varied influences, such 
as arise from increase or decrease in number of laborers ; 
increase or decrease in the amount of available land ; the 
progress of improvements ; the fluctuations in the interest 
rate. Let us now see how far we can apply the same 
reasoning to the determination of wages under conditions 
nearer like those of modern industry, confining ourselves, 
however, to those parts of the industrial field in which 
competition exists among employers on the one hand and 
among workmen on the other. 

The first fact that we must take into consideration is 
that we cannot assume that in this wide field of industry 
every workman can enter into direct competition with 
every other workman, and thus bring about an immediate 
equalization of wages. The journeyman tailor cannot be 



COMPETITIVE WAGES 163 

replaced by the excavator nor by the farm hand; the 
cotton-mill operative cannot take the place of the iron 
and steel worker. At any given time, then, there may be 
many rates of wages, not one universal rate. 

As we enter upon a study of the forces which are 
responsible for the differences , in wages in the various 
trades and occupations, we encounter a difficulty which 
has not hitherto arisen to vex us. How can we say what 
differences in general rates really exist ? In all our dis- 
cussion up to this point, we have spoken of equal rewards 
for equal services. Of course if one bricklayer does twice 
as much work as another, he is likely to receive twice the 
wages. But if a tailor receives twice the wages of a brick- 
layer, how can we say that it is because he does twice as 
much work? Clearly, it is not possible to reduce tailor's 
labor to terms of bricklayer's labor, so as to show whether 
one is rewarded more liberally than the other. 

13. Through the apportionment of new additions to the 
working force, wages in different occupations requiring 
equal natural endowments tend tozvard an equality. 

Let us suppose that there are half a dozen occupations 
in a community, all of which require of beginners about 
the same degree of intelligence, dexterity, and strength, 
although they differ as widely in their nature as bricklayer's 
and tailor's labor, so that no direct comparison of wages is 
possible. Is there any reason why differences in wages 
per day should exist ? At first, we should expect, the 
choice of occupations would be more or less a matter of 
chance. A boy would enter one of the trades because his 
father followed it; another, because his best friend in- 
tended to enter it, and so on. 

Once in the trade, a man would have to remain there, 
unless he wished once more to go through the tedious 
tasks of a beginner. The different trades would thus be 
walled off, as it were, one from the other. Mature reflec- 



164 INTRODUCTION TO ECONOMICS 

tion might convince a man that he had made a mistake in 
choosing his trade ; but this would not mend matters. His 
earnings would be wholly subject to the laws of his trade. 
If many men happened to be in the trade, and the demand 
for their services were limited, some of them would have 
to be set at unimportant tasks, which could not be well re- 
munerated. And competition among the men would force 
wages down to the level of remuneration of these. If 
the trade were but scantily supplied with men, all might be 
employed at work that could pay a high reward, and so a 
high rate of wages would prevail. In each trade the rule 
that marginal productivity determines wages would apply ; 
but marginal productivity would be unequal, for men of 
equal native ability, in the different trades. 

In every trade, however, a constant supply of new re- 
cruits is necessary to keep its ranks full, and the pros- 
pective apprentice has at any rate some freedom of choice. 
In one trade, he finds men discontented and impoverished ; 
in another trade, he finds every appearance of prosperity* 
Unless he is very blind, he will choose a trade in which 
the latter condition prevails. So the tide of apprentices 
sets steadily away from the underpaid trades, and in the di- 
rection of the better paid ones. Failing numbers, in the 
former trades, raise the marginal productivity of labor; 
increasing numbers, in the more prosperous trades, re- 
duce wages there. Whether this process will continue 
until perfect equality of rewards is established for men of 
equal native ability in different trades, we cannot say. 
The equalization depends upon the good judgment of 
the prospective apprentices in their choice of trades; 
and these, like all men, are likely to err. But gross 
inequality, under the circumstances, could hardly long 
persist. 

14. Permanent differences in competitive wages are caused 
by differences in the marginal productivity of labor ; original- 



COMPETITIVE WAGES 165 

ing in influences affecting the distribution of the supply of 
labor. 

Some of the differences in wages actually existing ap- 
pear to be fortuitous, as those assumed in the foregoing ex- 
ample. But many of these differences are clearly connected 
with the personal qualifications of the workman — his 
strength and skill, his intelligence and reliability. Others 
are connected with the different degrees of risk, agreeable- 
ness, and dignity of the employment itself. Still others de- 
pend upon trade union requirements, or legal restrictions. 
What we are concerned with here, however, is not to classify 
the causes of differences in the wages paid in different oc- 
cupations, but to see exactly how these causes operate. 

We know, for example, that a dangerous occupation is 
likely to carry with it a higher remuneration than a safe 
one; that an occupation requiring a long apprenticeship is 
ordinarily better paid than one requiring practically no 
training. Why may we not say, then, that a part of a 
man's reward is for labor, part of it for risk ? If a tedious 
apprenticeship is necessary, may we not say that part of 
the reward of the journeyman is a compensation for the 
time and trouble spent in learning the trade ? Such an 
explanation would be quite satisfactory if we actually 
found that, other things equal, wages were nicely graded 
according to risk, or to the length of the period of appren- 
ticeship — if, for example, we found that a workman in an 
occupation involving no appreciable risk received a wage 
represented by x, an equally efficient workman in an 
occupation involving a considerable risk received x+y t 
and a third workman, in an occupation twice as dangerous 
as the second, received x + 2y, and so on. But we do not 
find in real life any such simple rule as this. Danger- 
ous occupations, we often find, are very ill paid in compari- 
son with occupations requiring no greater natural ability 
and entailing no risk worth speaking of. Almost the least 



166 INTRODUCTION TO ECONOMICS 

remunerative occupation that an able-bodied citizen of the 
United States can engage in is that of soldier, and this 
in spite of the fact that the Federal government prides 
itself upon being a liberal employer. Certainly the risks 
of the occupation are considerable. A man who accepts 
employment as trainman on the American railways stands 
one chance out of one hundred and twenty of meeting a 
violent death within a year, and one chance out of nine of 
being injured. His average daily compensation will vary 
from $2.09, if he is a fireman, to $4.25, if he is an engi- 
neer. In either case, he is a man of more than average 
physical strength and general intelligence. If he is an 
engineer, he is also a man who has at least as much train- 
ing as the average skilled laborer. What we really find is 
that in some cases no allowance appears to be made for 
risk ; in more cases some allowance is made for it, but 
there is no apparent tendency for this allowance to vary 
regularly with the degree of risk. Similarly with dif- 
ferent degrees of skill. Ordinarily, the skilled laborer, 
who has undergone a long apprenticeship, receives a higher 
reward than the unskilled laborer of equal native intelli- 
gence. In some cases, however, this does not appear to 
hold true ; and it is idle to attempt to show that there is any 
ascertainable proportion between degrees of skill and dif- 
ferences of remuneration. So also with disagreeableness of 
work. Little, if any, allowance is ordinarily made for it in 
wages, although in some cases it seems to play a very im- 
portant part. Clearly, then, it is not enough to say that 
wages are affected by risk, by skill required, by disagreeable- 
ness of occupation. We must know how these causes 
operate, and why they operate with such irregularity. 

Let us see if a concrete example will not make clear 
the relation risk actually bears to wages. Imagine that a 
gunpowder factory is erected at a distance of a few miles 
from a city of some size, and let us suppose that five 



COMPETITIVE WAGES 167 

hundred workmen will be required, and that they will be of 
a grade of skill that would command an average of $3 a 
day in perfectly safe occupations. How much will it be 
necessary to add to this sum, to induce them to enter the 
powder works ? 

Now, the first question that is likely to arise is, How 
much danger is there that the works will blow up ? You 
do not know this, neither do I ; nor, we may venture to 
say, do the workmen whom it is sought to employ. Per- 
haps there is no danger at all in the present stage of the 
powder manufacture. Powder mills have often blown up, 
however, and most of us would prefer to stay out of them. 

In every community there are some men who do not 
seem to be in the least afraid of danger. They may know 
that destruction has befallen others, but, each argues, 
everybody can't be killed ; why should I be ? Such men 
have supreme confidence in their luck. Danger, real or 
imputed, does not influence their conduct. Now, if there 
are a thousand men of this kind in the city, it will be quite 
possible to man the powder mill without offering any more 
of an advance in wages than would have to be offered by 
an enterpriser who proposed to establish a new shoe fac- 
tory or nail mill. The powder manufacturer, as any one 
else starting a new enterprise, will offer wages a little 
higher than those prevailing in the city — ten cents more 
per day, perhaps. Not every one will jump at the 
chance to improve his wages ; but the men who despise 
danger will one by one leave their former employments 
and enter the doors of the powder mill. Presently wages 
will be reduced to the general level. No man will for this 
reason leave the mill, nor need the enterpriser care if a 
few should do so, for there are still plenty of men in the 
city who are not disturbed by fear of accident. 

But suppose that instead of one thousand such men, 
there are only one hundred. The powder manufacturer 



1 68 INTRODUCTION TO ECONOMICS 

will find that ten cents extra a day fails to bring the full 
complement of men. Perhaps he will offer twenty-five 
cents extra; and this may bring another hundred men, 
who fear for their lives, indeed, but desire the additional 
income extremely. An additional twenty-five cents may 
bring another hundred, more timid or less eager for high 
wages. At the rate of $i a day above the prevailing rate, 
the enterpriser may be able fully to man his works. 

Now, we may ask ourselves, is this extra dollar a com- 
pensation for risk ? Remember, there may be no real risk 
at all, and it may be that it is nothing but the name of 
powder that has kept the workmen back and forced up 
wages. And how is it that a powder manufacturer is able 
to pay men for risk, at their own estimate — very likely a 
mistaken one, too ? Well, the powder manufacturer is ex- 
periencing the ordinary incidents of his business. Every- 
where powder manufacturers have to contend with the 
same indisposition on the part of the ordinary workman 
to enter their mills. Everywhere the amount of available 
labor is limited, relatively to the demand for it. And so 
the productivity of a laborer, measured in value of powder 
produced, is high, and wages may be high accordingly. 
If, however, the number of men who do not mind the 
danger were sufficient fully to man all the powder works, 
more powder would be produced, its value would be less, 
and the productivity of labor, in value, would fall until it 
corresponded with that of labor in other occupations re- 
quiring equal skill. 

If the risks to life and limb undergone by locomotive 
firemen and engineers were reduced by fifty per cent, 
through the introduction of better safety appliances, the 
improvement of track, etc., how much could wages be re- 
duced? I have never heard of a railway president who 
proposed to spend the company's money in reducing the 
chances of accident with the expectation that part of the 



COMPETITIVE WAGES 169 

cost might be met by a reduction in wages. Nor do we 
find that wages are particularly high in the sections of the 
country where transportation is conducted at the greatest 
cost in life and limb. Here, it appears, is a case in which 
a great industry is able to rely upon the existing supply of 
men who bear risks cheerfully, without any extra compen- 
sation. The marginal laborer, in transportation, is no more 
productive than the marginal laborer in general industry ; 
therefore he is no better paid. 

15. The standards of living of the working class , through 
limiting the supply of labor, may affect marginal produc- 
tivity, and, therefore, may affect wages. 

Finally, we may consider the effect of the so-called 
" standard of living " upon productivity and wages. There 
are some who believe that wages are adjusted to the aver- 
age needs of the workman ; and if these needs increase, 
wages must rise. What a man feels that he must have, in 
the way of the material necessaries and comforts of exist- 
ence, is his standard of living. This, according to certain 
optimistic social philosophers, he will get. Accordingly, 
if you are modest in your demands, you will receive a 
modest stipend ; if you are convinced that the world owes 
you not only a living, but a good living, the world will 
kindly accommodate itself to your view of the matter. 
Certainly, this theory is a far more agreeable one, and far 
easier to grasp, than the laborious one presented in this 
chapter. How much truth is there in it ? 

If you are planning to become a physician, you are likely 
to seek the counsel of some who are now practicing the 
profession. You will probably receive some such advice 
as this: " Whatever you do, don't make a physician of 
yourself. A physician must dress well ; he must live 
in a good house; he must keep a carriage; in short, 
he must live at great expense, and in the majority of 
cases, he will find great difficulty in obtaining an adequate 



170 INTRODUCTION TO ECONOMICS 

income." Now, what this means is that physicians have a 
comparatively high standard of living, and that their aver- 
age incomes are scarcely sufficient to meet all the demands 
upon them. You may not be deterred by the doleful 
account of the physician's financial difficulties. But is it 
not probable that, in the length and breadth of the land, 
hosts of young men are in this way turned to other pro- 
fessions ? If, on the other hand, the majority of physicians 
were recommending their profession as one in which a 
good living is assured, is it not likely that many young 
men would be attracted to the profession ? In the former 
case the average income of the physician is likely to be 
increased by the growing scarcity of competent medical 
men ; in the latter case it is likely to be decreased by in- 
crease in numbers. 

If, then, the earnings in a profession or trade are not 
sufficient to command, on an average, the necessaries and 
comforts that are deemed essential to happiness, some in- 
fluence is exerted upon those entering the profession or 
trade. The standard of living thus exerts some slight 
influence, at least, upon wages. 

In the example just given, the effectiveness of the stand- 
ard of living in one profession depended upon the absence 
of a similar standard in other professions. Suppose that 
after getting the opinion of a physician as to the advisa- 
bility of entering his profession, you apply to a lawyer for 
his opinion on law as a profession. " Whatever you do, 
avoid the law," he will probably tell you. Next, you go 
to one who has chosen journalism. "I pity a young man 
who selects journalism as his profession," is probably what 
you hear. Then you go to a teacher. He shakes his head. 
" If I were a young man, I should choose some other pro- 
fession." Indeed, if you do not happen upon one of the 
few optimists who still survive, you are likely to conclude 
that you may as well choose the profession toward which 



COMPETITIVE WAGES 171 

you were originally inclined, since all the professions seem 
to be inadequately paid. The fact is that most of us think 
that we need more than we get ; and the result is that no 
one profession is able to frighten aspiring youths into 
choosing some other line of activity. The standard of 
living of any profession, therefore, has little effect upon 
its average earnings. 

Suppose, however, that a whole nation, practically, is 
affected by this feeling of discrepancy between income 
and need. A considerable proportion of its young men 
will marry late or not at all, children will be few, and, if 
immigration is not active, the population will gradually 
decline. In every occupation, men will be withdrawn from 
the less important tasks ; the less fertile fields and the less 
productive mines will be abandoned. The marginal prod- 
uctivity of labor, and the average rate of wages, will in- 
crease. On the other hand, if a nation consists of people 
who will thankfully receive little if they cannot get much, 
who will forego one luxury or comfort after another rather 
than change their traditional mode of life, no check upon 
population will exist, until the bare necessaries of existence 
are insufficient for all. Here, as elsewhere, it is because 
the productivity of labor is low that wages will be low. 
Such people will obtain only a bare minimum of existence, 
because that is all the marginal laborer is worth, not be- 
cause that is all he needs. 

We may now sum up the principles which we have 
sought in the foregoing long array of apparently unrelated 
examples. The marginal productivity of labor is under 
competition the immediate determinant of wages. Risk 
or disagreeableness of labor, the skill required, the bar- 
riers to be surmounted, the standard of life, may all affect 
the rate of wages, but only in so far as they affect the 
marginal productivity of labor, through determining its 
supply. 



172 INTRODUCTION TO ECONOMICS 

16. Summary. 

In the widest use of the term, wages include any income 
originating in labor. In a narrower sense wages are the 
price paid by one person for another person's services. 

While the productivity of labor varies with the conditions 
under which labor is employed, wages for tasks of equal 
difficulty tend toward a uniform level. This level is deter- 
mined by the addition to product made by the laborers who 
might be most easily dispensed with, or the marginal 
laborers. 

Wages tend to rise or fall with increase or decrease in 
the personal efficiency of labor. An increase in the labor 
supply, other things equal, reduces wages. Improvements 
in production usually tend to raise wages, as does also 
reduction in interest rates. 

There is little direct competition between laborers in 
the several occupations; but the apportionment of the 
supplies of new labor tend to prevent any great inequality 
in the rewards of men of equal natural ability. Permanent 
differences in wages are the result of barriers preventing 
the free flow of labor from one field to another, such as a 
long period of apprenticeship, risk, trade union regulations. 

The standard of living can affect wages only through 
reducing the supply of labor. When the wages paid in a 
given industry are not high enough to meet the require- 
ments of the existing standard of living, young men may 
be discouraged from entering the industry, and hence wages 
will tend to rise. When general wages are inadequate, in 
view of the general standard of living, increase in . popula- 
tion may be checked, and thus wages may be raised to a 
higher level. 



CHAPTER XI 
WAGES AS AFFECTED BY LABOR ORGANIZATION 

1. Where laborers are not in a position to deal with their 
employers on substantially equal terms, actual wages may 
remain below the level fixed by marginal productivity. 

In the last chapter we saw that under full and free com- 
petition wages are fixed by the productivity of labor 
employed under the least favorable conditions. What 
laborers produce, in the least productive fields, mines, and 
factories that are actually under operation, sets the standard 
toward which the wages of all labor tend. In many cases, 
however, actual wages fall below this standard. The posi- 
tion of the laborer in bargaining with the employer is often 
very weak. The employer needs workmen just as the 
laborer needs employment; but the need of the laborer 
is usually far more pressing than that of the employer, 
since the former has no adequate reserve to draw upon 
for his living expenses, while the latter has such a reserve 
in his capital. Where industry is conducted on a large 
scale, the employer can without serious inconvenience 
dispense with the services of any one of his numerous 
employees. An employee, on the other hand, cannot 
abandon his position without running the risk of a long 
period of unemployment. Under the conditions, there 
is every reason why the labor contract should, in a majority 
of cases, be more favorable to the employer than to the 
employee. Average wages will be less than the average 
value of labor, measured by marginal productivity standards. 

2. When the terms of employment are fixed, not by agree- 
ment between the employer and individual workmen, but by 

173 



174 INTRODUCTION TO ECONOMICS 

agreement between the employer and an organized body of 
workmen, wages conform more closely to productivity 
standards. 

The disadvantages under which the workmen suffer are 
in large measure removed by effective organization. The 
employer may be able to get on very well without the 
services of a particular employee ; but if all his employees 
quit his service at one time, he is likely to suffer severe 
losses. The employer may have customers whose needs 
must be supplied, if they are to be kept from opening 
business relations with his competitors. He may have 
notes falling due, which can be renewed only if his business 
gives evidence of prosperity. A prolonged stoppage of 
work may result in the employer's ruin; in any case, 
it is likely to inflict serious injury upon him. Rather than 
accept such an evil, he is disposed to make concessions 
to his employees, so long as their demands do not appear 
exorbitant. Indeed, there are cases in which the employer 
can be compelled to pay his men more than their labor is 
worth, according to the general standard that the industry 
can, in the long run, afford. But these cases are rare, and, 
in a general study of the effects of labor organization upon 
wages, may be ignored. 

3. The typical form of labor organization is the trade 
union, an association of laborers employed in the same trade. 

In a trade which has become well established, a natural 
basis for organization is found in the mutual sympathy of 
those whose lives are passed under like conditions. One 
carpenter knows how to evaluate the problems of life and 
work of another carpenter. Even where there is no formal 
organization in a trade, we find a tendency among the mem- 
bers to work in harmony. They assist one another in 
finding work ; members of the trade who are prosperous 
contribute to the support of those members who fall ill or 
are otherwise overtaken by misfortune. Moreover, the 



WAGES AS AFFECTED BY LABOR ORGANIZATION 175 

typical workman is reluctant to underbid a fellow-workman 
of the same trade in his dealings with an employer. Com- 
petition, then, is materially restricted even in trades with- 
out a formal organization. 

With the appearance of a class of large employers, the 
inchoate organization of labor developed into the formal 
organization which we call the trade union. In its simple 
form, the trade union is an association of all, or of a 
large proportion, of the men exercising a trade in a given 
locality. The association has regular meetings where the 
conditions of employment are discussed, and rules are 
adopted governing the conduct of members. Officers are 
elected for the purpose, of systematizing the work of the 
association, and of enforcing its rules. 

It is rarely the case that all persons in the trade are 
members of the union. Some workmen are averse to the 
restrictions upon their personal liberty that unionism rep- 
resents ; some are unable or unwilling to assume the finan- 
cial responsibilities that membership entails. Where the 
strife between the workers and the employers is not intense, 
the relations between members of the union and non-mem- 
bers may be entirely amicable. The non-members work 
alongside the members, and demand and receive the same 
wages. Where the union laborers are engaged in a con- 
flict with their employers, they usually manifest hostility 
to the non-union men, since the latter may accept employ- 
ment, to the great injury of the cause of the union, and in 
any event fail to carry their fair proportion of the burden 
of the struggle, though hoping to profit by it. 

4. As a matter of practical policy, a strong trade union 
usually endeavors to induce all men exercising a trade to be- 
come members of the organization. Sometimes union men 
are forbidden to work for employers who employ non-union 
men. This is known as the " closed shop " policy. 

It is evident that the presence in an industry of a large 



176 INTRODUCTION TO ECONOMICS 

number of men who take no part in the existing labor 
organization materially weakens the position of the organi- 
zation. The union, therefore, uses every means to per- 
suade all persons in the trade to become members of the 
organization. If any refuse, and the union possesses the 
necessary strength, it forces them to become members by 
harassing employers who admit the non-union men to 
their shops. This policy is often denounced by represent- 
atives of the employing class as an unwarranted interfer- 
ence in the rights of the non-union men. It is further 
denounced as an attempt to compel the employer to assist 
the union in controlling its membership. Whether the 
closed shop policy is justifiable or not depends entirely 
upon the general policy of the union. If it admits to 
membership all men having the necessary qualifications 
for the work to be done, upon payment of reasonable 
membership fees, it is difficult to see how the men who are 
compelled to become members have any real grievance. 
So long as the demands of the union for higher wages or 
shorter hours are moderate, the impartial outsider cannot 
censure the organization for making its position as strong 
as possible. 

5. The trade union, whenever possible, places limits upon 
the number of persons admitted to the trade. 

If the wages of skilled workmen in any trade rise much 
above the general level, there is likely to be an influx of 
laborers from other employments, whose presence in the 
trade has the effect of reducing wages. In some cases the 
free admission to a trade of all who desire to exercise it 
would reduce wages below the normal level. In the build- 
ing trades, for example, wages appear to be higher than 
they really are. The members of these trades receive 
high wages for the time they are employed, but employ- 
ment is very uncertain. In the greater part of the 
country, the winter represents a slack season in which 



WAGES AS AFFECTED BY LABOR ORGANIZATION 177 

very few members of the building trades find steady- 
employment. This irregularity of employment does not 
receive due consideration from young men who are about 
to choose a trade; hence unrestricted admission to the 
trade might easily depress annual earnings below the 
normal level. 

Restrictions upon entrance to a trade may take the 
form of apprenticeship regulations that are sufficiently 
onerous to reduce the number of beginners. Formerly, a 
seven-year apprenticeship was required in many trades. 
During the period of apprenticeship, the worker received 
no wages, and this in itself narrowly limited the number 
of persons who could afford to enter a trade. In some 
trades, an apprenticeship of three or four years is still 
required. 

Another method of limiting the number of apprentices 
is to prescribe the proportion of apprentices to trained 
workmen that an employer may have in his shop. In the 
job printing offices of New York City, one apprentice is 
allowed to every office employing as many as eight men, 
and for every additional eight men an additional appren- 
tice is allowed ; but no office may employ more than seven 
apprentices. The work that apprentices are allowed to do 
is hedged about by restrictions that prevent the employer 
from gaining much profit from it. 

It is easy to see that through such restrictions upon ap- 
prenticeship an artificial scarcity of labor in any one trade 
may be created, and wages may be kept at an abnormally 
high level. Those who are prevented from exercising the 
trade are forced into occupations where such limitations 
upon the labor supply are impracticable, thus depressing 
wages in those occupations. Consumers of the products 
of industries in which labor holds a monopolistic position 
are forced to pay abnormally high prices. There are, 
however, very few trades strong enough to raise wages 



178 INTRODUCTION TO ECONOMICS 

much above the level that the degree of skill necessary 
would, in the long run, command, even if admission to the 
trade were perfectly free. 

6. The position of a trade union is greatly strengthened 
by the accumulation of funds for the relief of members in 
time of sickness or unemployment. 

The mere wage earner is at all times exposed to the 
danger of want as a consequence of accident, sickness, or 
prolonged unemployment. What he can save individually 
is seldom sufficient to carry him through a long period of 
time in which he earns nothing. The trade union, by col- 
lecting contributions from those members who are receiv- 
ing wages, and by distributing the money among those 
who are in need, greatly reduces the uncertainties of the 
laborer's lot. A plan of mutual insurance binds to the 
union many who would otherwise . hold themselves aloof 
from it. Moreover, it keeps those who are out of work 
from offering their services to the employer at a reduced 
rate of pay, and thus prevents the demoralization of the 
labor market. 

But the most important object to be attained through the 
accumulation of funds is the strengthening of the union in 
a dispute with the employer. With a large fund, a union 
may be able to keep its members from accepting work 
through a period of several months — long enough to in- 
flict serious losses upon a recalcitrant employer. A union 
without funds may be easily starved into submission to the 
employer's conditions. 

7. The position of a union is strengthened by an alliance 
with unions in related trades, or even in unrelated trades. 

Such trades as the carpenters, the masons, the plasterers, 
and other, building trades, have much to gain through 
working in harmony. At one time the carpenters may 
have a strong organization, and the masons a weak one ; 
at another time the reverse may be true. On one job a 



WAGES AS AFFECTED BY LABOR ORGANIZATION 179 

small number of masons may be needed, and a large num- 
ber of carpenters. In such cases, the union masons could 
perhaps be replaced by the non-union masons that are to be 
found in every city, while it would be more difficult to secure 
a sufficient number of non-union carpenters. The building 
contractor must have men of each trade, and if he engages 
in a dispute with the union whose position is weak, pressure 
can be brought upon him by the union whose position is 
strong. A harmonious organization of allied trades can 
thus always place its strongest forces at the front. 

An advantage of a different nature arises from an alliance 
of unions in unrelated trades. The cigar makers' union 
can bring no direct pressure to bear upon the employers of 
garment workers ; but when the garment workers are 
thrown out of employment by a strike, the cigar makers 
can contribute to their support. At another time contribu- 
tions from the garment workers may assist the cigar makers 
in securing better terms from their employers. 

In the principal industrial centers of the United States, 
both kinds of alliances are found. All trades form a loose 
organization known as the Central Labor Union ; related 
trades, such as the building trades, form closer organiza- 
tions, known under various names in the different cities. 

8. A trade union in one locality is strengthened by an 
alliance with unions in the same trade in other localities. 

In a period of such easy communication as the present, 
a purely local labor organization can accomplish little. In 
a dispute between the labor organization and an employer, 
the latter can quickly import laborers from other localities 
to replace his former employees. Apprenticeship regula- 
tions in one locality are enforced in vain, if in other locali- 
ties the labor market is overstocked through unrestricted 
apprenticeship. 

Even when no importation of labor takes place, the local 
union finds difficulty in raising wages or reducing working 



180 INTRODUCTION TO ECONOMICS 

time. Such measures represent a cost to the employer, 
and if the product is one which must enter into competition 
with like products from other localities, the concessions 
that the employer can make to his employees are narrowly 
limited. If the textile workers of Fall River demand 
higher wages, the employers may be unable to grant the 
demand without raising the price of cloth to such an extent 
as to encourage the competition of other textile manufactur- 
ing districts. 

The importance of a central organization appears nowhere 
more clearly than in the case of industries in which exten- 
sive consolidations have been formed. If the laborers in 
one steel plant demand higher wages, the plant can be 
closed down, and the orders executed in other works where 
there is no trouble with the laborers. The employer loses 
practically nothing, and the laborers are in the end com- 
pelled to return to work on such terms as the employer 
may dictate. 

In any event an organization covering a wide range of 
territory affords an. excellent means of raising funds for 
local organizations in time of labor disputes. When the 
cigar makers of New York are on strike, the cigar makers 
in Philadelphia, Boston, Chicago, and other cities raise 
funds for their support. 

The foregoing considerations have led to the formation 
of national or international unions in almost every impor- 
tant trade. In government these organizations are some- 
times loose federations, sometimes strongly centralized 
bodies. In the centralized unions the local union is re- 
quired to obtain the consent of the national union before 
inaugurating a strike ; the national officers can call a strike 
in any locality, even if the members of the local organiza- 
tion are content with their condition. The essence of the 
power of the national union is its control over the funds 
that are accumulated for emergencies. A local union 



WAGES AS AFFECTED BY LABOR ORGANIZATION 181 

which goes on strike without proper authorization forfeits 
its claim for strike benefits from the national organization ; 
a local union which refuses to strike when ordered to do so 
is suspended or expelled from the national union, and is 
subjected to more or less severe discipline before it is rein- 
stated in the organization. 

9. National organizations have much to gain through a 
central organization covering the whole field of industry. 

In the United States most of the national unions are 
associated in a great central organization known as the 
American Federation of Labor. This organization fur- 
nishes a means by which the support of the entire trade- 
union world may be given to unions engaged in an extended 
contest with their employers. The American Federation 
pretends to no direct control over its constituent members, 
but unions about to engage in a labor dispute naturally 
consult with the officers of the Federation and seek the 
cooperation of that body. The American Federation col- 
lects information relating to the entire field of labor and 
assists in organizing unions in new fields. When disputes 
arise between different labor organizations, the Ameri- 
can Federation officials act as arbitrators ; when factional 
strife causes the disruption of a union, the officers of the 
Federation are active in effecting a reorganization. With 
the lapse of time the American Federation will probably 
gain additional strength, and will demand a voice in all 
questions of general importance to the laboring class. 

10. The principal weapon in the hands of organized labor 
is the strike. A strike is a concerted suspension of zvork 
for the purpose of enforcing some demand tipon the em- 
ployer. 

Sometimes the mere fact that demands are presented to 
the employer by an organization including his entire work- 
ing force leads to concessions that would never be made 
to isolated employees. In many cases, however, the em- 



1 82 INTRODUCTION TO ECONOMICS 

ployer refuses to consider the demands of his employees, 
and a strike is called. It is possible that the employer 
would be unable to grant the demands even if he desired 
to do so. In perhaps a majority of instances the demands 
could be granted in part or wholly without serious loss 
to the employer. At all events the laborers believe this, 
and in suspending work they feel that they are merely 
stopping operations long enough to reach a satisfactory 
adjustment of the matters in dispute. Sometimes the 
employer takes the same view of the matter and makes 
no attempt to replace his striking workmen. 

If the employer feels that the demands of the men are 
wholly unreasonable, he is likely to attempt to fill the 
places left vacant with laborers who are not controlled by 
the organization of the strikers. This the latter must pre- 
vent, if they are to have any chance of winning. If there 
is nowhere to be found an adequate number of laborers 
willing to work as strike breakers, the strikers may be 
content to allow the employer to experiment with ineffi- 
cient men. If the efforts of the employer to secure 
laborers appear to be successful, the strikers endeavor to 
persuade the strike-breaking laborers to join in the sus- 
pension of work. "Pickets" are stationed at the en- 
trance to the works, to inform all men coming to their 
tasks that a strike is in progress. If the strike breakers 
do not yield to peaceable persuasion, the pickets often 
resort to intimidation. Where the contest becomes very 
bitter, the strikers sometimes employ violence to frighten 
the strike breakers from their work. The employment of 
violence is discountenanced by the leaders of the strike ; 
nevertheless, a great strike has seldom been entirely free 
from instances of injury inflicted upon strike breakers. 

11. A second weapon of organized labor is the boycott. 
A boycott is an association having for its purpose the destruc- 
tion of the business of an employer through pressure brought 



WAGES AS AFFECTED BY LABOR ORGANIZATION 183 

to bear, directly or indirectly, upon those who have business 
relations with him. 

When men are on strike, they naturally refrain from 
purchasing the products of their former employer, and 
persuade their friends to follow the same course of action. 
This is a simple form of the boycott; it may be fairly 
effective when the product is destined for local consump- 
tion by the working class. An employing baker, for 
example, may be brought to terms in this way. Where 
the product is placed upon a general market the boycott 
takes a more complex form. The whole trade-union 
world may be warned not to buy the products of the 
offending employer. This may be done through the pub- 
lication in the trade journals of the name of the employer 
who is the subject of attack. For a long time an " unfair 
list," a list of the names of such employers, was published 
by the organ of the American Federation of Labor. This 
form of boycott has been held by the courts to be illegal, 
but it is practically impossible to do away with it. 

Sometimes the boycott takes a very roundabout course. 
A merchant is boycotted for handling the products of an 
" unfair " shop ; laborers are boycotted for buying goods 
from such a merchant ; men who employ these laborers 
are boycotted, and so on. These roundabout boycotts 
are not very frequent nor very important. They are of 
doubtful value to the laborers' cause, as they inflict more 
hardship upon innocent parties than upon the persons 
against whom they are ultimately directed. 

12. Strikes and boycotts may be carried on by workmen 
who have no formal organization. 

We have spoken of strikes and boycotts as the weapons 
of organized labor. As a fact, however, a great many 
strikes take place in trades that are not organized in 
unions. For the purpose of carrying on a strike a tem- 
porary organization is effected which may be abandoned 



184 INTRODUCTION TO ECONOMICS 

when the strike is won or lost. Boycotts, under one name 
or another, have often been employed by unorganized 
laborers. 

Even in an organized trade it often happens that the 
non-union men join the union men in striking. .This was 
the case in the last strike of the Fall River textile workers 
and of the anthracite coal miners. In such cases the or- 
ganized laborers usually assume the leadership. 

It is not certain whether the formation of trade unions 
leads to an increase or to a reduction in the number of 
strikes. It is undoubtedly true that a permanent organ- 
ization results in a reduction in the number of strikes 
having no adequate cause. A trade union develops re- 
sponsible leaders who do everything in their power to 
prevent a strike when the chances of winning are small. 

13. In many trades where powerful organizations have 
been established, the terms of employment are fixed, not by 
bargaining between the employer and the individual work- 
men, but by agreements between representatives of the 
laborers, on the one hand, and representatives of the employers, 
on the other. This plan of fixing the terms of employment 
is known as collective bargaining. 

In the bituminous coal district of the North Central 
states representatives of the miners and representatives of 
the mine operators meet annually to determine the rate 
of wages to be paid. In these meetings all the circum- 
stances of the industry are fully discussed, — the prices 
that the product is likely to command, the cost of placing 
it on the market, the cost of living of the workmen, the 
wages paid in other districts, etc. As a result of the dis- 
cussion each side gains a fairly clear understanding of the 
position of the other. It becomes impossible for the la- 
borers to insist upon terms that the employers cannot 
possibly grant, as not infrequently happens where no 
machinery for collective bargaining has been established. 



WAGES AS AFFECTED BY LABOR ORGANIZATION 185 

Differences of opinion as to what constitutes a fair wage 
naturally arise ; but through full discussion and mutual 
concessions these differences are prevented from causing a 
rupture of negotiations. Since the adoption of the plan of 
joint conferences agreements have always been reached, 
and have in most cases been loyally observed by both em- 
ployers and employed. 

In a number of other American industries similar meth- 
ods of collective bargaining are employed, and in England, 
where trade unionism is more powerful than in any other 
country, all the great industries establish the conditions of 
employment by collective bargaining. 

It is clear that in a complex modern industry, only the 
more general conditions of employment can be fixed by 
such agreements. Minor disputes will constantly arise 
relating to the interpretation of the general agreement. 
Provision is usually made for the settlement of such dis- 
putes by a committee representing both the workmen and 
the employers. Where such a committee is unable to 
reach a decision, resort is had to the services of an impar- 
tial outsider who acts as arbitrator. 

In some industries there is a general understanding that 
if no agreement as to the renewal of the contract can be 
reached, the matters in dispute shall be settled by arbitra- 
tion. Such arbitration, however, is not always successful, 
since either the laborers or the employers may prefer to 
submit to a trial of strength rather than accept the onerous 
conditions of the arbitrators' award. 

14. When a strike has been in progress for a long time, 
and both parties to the dispute are thoroughly wearied with 
it, though either is unwilling to surrender its claims, resort 
may be had to arbitration. 

In perhaps a majority of the important strikes of recent 
years each party to the controversy has taken a position 
which is not wholly defensible. The demands of the men 



1 86 INTRODUCTION TO ECONOMICS 

are excessive, and the terms that the employer insists upon 
are unnecessarily onerous to the men. Negotiations are 
broken off and a strike follows, to the serious injury of both 
parties. As the burdens of the struggle grow heavier, 
each party sees that its original position was untenable, 
but shrinks from making concessions, fearing that to do 
so would be to confess itself worsted in the struggle. 
The only way in which the difficulty can be settled without 
loss of prestige to either party is through submission of the 
matters in dispute to arbitrators mutually agreed upon. 
Both parties bind themselves to accept the award of 
the arbitrators in good faith, and instances are rare in 
which this agreement is disregarded. The award of the 
arbitrators is seldom anything more than a balancing of 
concessions ; it usually satisfies neither party, but is ac- 
cepted as a lesser evil than a continuance of the struggle. 

15. Arbitration may be forced upon the parties to an in- 
dustrial dispute by the pressure of public opinion. 

While the persons most seriously injured by the continu- 
ance of an industrial dispute are the laborers and employ- 
ers directly involved, no important strike can be conducted 
without injury to the public. In the Chicago teamsters' strike 
of 1905, while the losses to the strikers and the employers 
were estimated at about $3,000,000, the loss to the business 
men of the city was estimated at several times that amount. 
A strike of railway laborers almost inevitably injures inno- 
cent parties more than it injures the railway companies 
against which the strike is directed. The blocking of the 
street railway system of a great city through a strike in- 
flicts immeasurable injury upon the general public. The 
anthracite coal strike of 1902 occasioned great distress 
among the poorer classes of those parts of the country 
that are dependent upon anthracite coal for fuel ; the re- 
sulting high price of coal caused the closing down of many 
shops and factories with consequent losses in wages and 



WAGES AS AFFECTED BY LABOR ORGANIZATION 187 

profits. In almost every great strike instances of violence 
are frequent, and the charges upon the public for maintain- 
ing the peace are greatly increased. 

Accordingly there are the best reasons why persons 
representing the interests of the public should undertake 
the task of bringing about a reconciliation between the 
employers and their striking employees. In some cases 
those who undertake this task limit themselves to inducing 
the disputants to meet in conference to discuss the matters 
at issue. This may of itself lead to a settlement of the 
dispute. Such intervention is known as conciliation. In 
other cases an attempt is made to force the disputants to 
submit to arbitration. Thus in the coal strike of 1902 Presi- 
dent Roosevelt induced the coal mine operators and the 
miners to submit the dispute to an arbitration commission 
appointed by himself. In a similar manner Governor 
Douglas, of Massachusetts, effected a settlement of the 
Fall River strike of 1904. 

16. // would be a great gain to society if industrial dis- 
putes could be submitted to arbitration as soon as they arise, 
instead of toward the close of a long contest. 

No argument is necessary to show that a strike is a 
wasteful way of establishing the conditions of employment. 
Since a settlement is likely to be effected by arbitration, 
why is a long and expensive struggle necessary ? Why do 
not the disputants resort to arbitration at the outset ? 

In most cases an industrial dispute is based upon irrecon- 
cilable differences of opinion. The employer offers what 
he considers the fairest terms he can afford to give; he 
believes that the laborers will be compelled to accept these 
terms in the end. The laborer demands what he regards 
as the lowest wages that he can accept in the circum- 
stances ; he believes that the employer will in the end be 
compelled to concede his demands. Arbitration would 
almost certainly result in terms that each party to the con- 



1 88 INTRODUCTION TO ECONOMICS 

troversy would regard as unfair to itself. Consequently 
each party prefers to resort to a trial of strength. After 
the struggle has continued for some time, and each party 
has gained an insight into the real strength of the other, 
the necessity of mutual concession becomes apparent to 
every one concerned. Terms that would, at the outset, 
have been spurned by both parties can be accepted, though 
perhaps reluctantly, by both the employer and the employee. 

It is accordingly clear why a plan of purely voluntary 
arbitration is ineffective as a means for preventing strikes. 
Many of our states have created commissions or boards of 
arbitration with authority to settle industrial disputes upon 
the application of both contestants. The services of these 
officials are not often requested. 

In New Zealand employers and organized laborers are 
required by law to settle their disputes without recourse to 
strikes. The colony is divided into districts in each of 
which a board of conciliation exists which is authorized to 
inquire into all labor disputes with the purpose of effecting 
a settlement by mutual agreement. If the parties to the 
dispute cannot be brought to an agreement, the dispute is 
referred to the court of arbitration, which hears both sides 
and renders a decision which is binding. Under the New 
Zealand system the strike has been eliminated. Whether 
such a system would be satisfactory under the complex 
conditions of American industry is somewhat doubtful. 
In this country compulsory arbitration is regarded with 
disfavor both by employers and by organized labor. 

17. The organization of labor modifies the operation of the 
competitive law of wages, but does not subvert that law. 

It has often been noted that in times of prosperity labor 
organizations are usually able to force a rise in wages ; in 
times of depression such organizations are unable to check 
a decline in wages. In times of prosperity the trend of 
wages, both of organized and of unorganized labor, is up- 



WAGES AS AFFECTED BY LABOR ORGANIZATION 189 

ward ; in times of depression it is downward. In economic 
terms prosperity means an increase in the value product 
of labor, and the laws of competition compel the employers 
to raise wages accordingly. Depression means a reduction 
in the value product of labor, and hence results in a 
reduction in wages. 

But the competition of employers is never very acute, 
and for a long time they may fail to raise wages, although 
the general circumstances of industry justify higher 
wages. It is only as increased profits lead to an expansion 
of industrial operations and an increased demand for labor 
that the competition of employers takes the form of an 
increase in wages. Labor organization may force an ad- 
vance in wages long before the competition of employers 
would lead to the same result. By virtue of organization 
the laborer shares more promptly, and probably more liber- 
ally, in the increased productivity of industry than he would 
if he relied upon his individual bargaining power. 

While we must grant to labor organizations an impor- 
tant influence in maintaining a high level of wages, we 
must not forget that this influence may easily be over- 
estimated. Wages are higher in America than in England, 
not because our labor organizations are stronger than 
those of England, — for the reverse is true, — but because 
labor is more productive in this country than in England. 
Wages will remain at a high level in this country so long 
as the high productivity of labor is maintained; and no 
form of organization can long maintain wages in the face 
of declining productivity. 

18. In so far as labor organizations tend to reduce the 
efficiency of labor, their ultimate effect upon wages is 
injurious. 

Labor organizations do not always confine themselves 
to the function of securing the highest pay for a given 
service ; in many cases they endeavor to reduce, as far as 



i go INTRODUCTION TO ECONOMICS 

possible, the service rendered for a given wage. They en- 
deavor to reduce the number of hours in the working day ; 
they place checks upon the amount of work that each man 
may turn out in a day; they sometimes discourage the 
introduction of devices that increase the effectiveness of 
labor. These policies do not always result in a reduction 
in productivity. In the long run a laborer may be able to 
accomplish more in an eight-hour day than in a ten-hour 
day. Excessive speed may quickly wear the laborer out, 
and render him incapable of performing tasks of a high 
degree of importance. So far as labor organization limita- 
tions lead to a conservation of the energies of the work- 
man, they increase the productivity of labor, in the long 
run, and make possible an advance in wages. 

Instances, however, are not lacking of restrictions that 
aim at compelling the employer to increase the number of 
men employed for the performance of a given amount of 
work. Many laborers cherish the illusion that society 
offers only a definite amount of employment, and that if 
one man increases the measure of his performance, he 
takes employment away from some other man. An entire 
laboring class may become infected with this fallacious 
view, and everywhere reduce efficiency to its lowest terms. 
Sooner or later employers find themselves unable to pay 
the existing rate of wages; if the organization is power- 
ful enough to prevent, for a time, a reduction in wages, 
employers reduce their working force; an "army of the 
unemployed " is created ; and in the end the organization 
breaks down under the competition of the laborers ex- 
cluded from employment. 

19. Summary. 

The individual workman is often at a serious disadvantage 
in bargaining with his employer; hence wages will often 
be less than the worth of the laborer's services. This in- 
equality may be corrected by an organization of workmen, 



WAGES AS AFFECTED BY LABOR ORGANIZATION 191 

all of whom present their demands upon the employer 
simultaneously. 

The trade union is an association composed of workmen 
employed in the same trade. When such an organization 
is formed an attempt is made to induce all the men practic- 
ing the trade to become members. After the organization 
gains practical control of a trade, it usually endeavors to 
limit the number of men admitted to the trade, in order to 
maintain a high level of wages. 

A trade union's position is greatly strengthened if it 
undertakes the relief of its members in time of sickness, 
accident, or unemployment The principal function of 
trade union accumulations is the maintenance of the 
members of the union in time of strike. Each local union, 
further, is greatly strengthened by alliances with other 
unions in the same locality or in other parts of the country. 

The chief weapons of the trade union are the strike and 
the boycott. Where trade unions are strong they are often 
able to make satisfactory terms with their employers with- 
out resort to the strike. In many cases the terms of em- 
ployment are established by agreement between the em- 
ployers on the one hand and representatives of the trade 
union on the other. 

Disputes between employers and workmen are some- 
times settled by arbitration, without resort to a strike. In 
cases of prolonged struggles between employers and em- 
ployees, public opinion may compel a submission of the 
matters in dispute to arbitration. In New Zealand all 
disputes between employers and organized laborers must 
be settled by arbitration. 

Labor organizations increase general wages in so far as 
they prevent the employer from taking advantage of the 
weakness in bargaining of the individual workman, and in 
so far as they increase the efficiency of labor. Through 
restrictions upon output they sometimes reduce the prod- 
uctivity of labor and so tend to reduce general wages. 



CHAPTER XII 

THE PRODUCTIVITY OF CAPITAL 

1. The term " capital goods " may be employed to designate 
objects of wealth that yield an income. 

Men who are engaged in business commonly divide 
their material possessions into two classes ; those that 
are held for the money income they yield, and those that 
are held for the immediate satisfaction they afford. The 
objects composing a merchant's stock in trade, his build- 
ings and fixtures, belong to the former class. The mer- 
chant's watch, the clothes he wears, the horse he rides 
for recreation, belong to the latter class. The former 
class we shall call " capital goods " ; the latter, " con- 
sumer's goods." When a man buys capital goods, he is 
commonly said to " invest money." When he buys con- 
sumer's goods, he is said to " spend money." 

The distinction, it is true, is not so easily drawn as 
might at first appear. Is a man's house to be classed with 
his capital goods ? The income that it affords is primarily 
one of satisfaction, like that afforded by a watch or a 
saddle horse. The possession of a house saves the pay- 
ment of rent, and to this extent adds to one's disposable 
income. 

Reflection will show, however, that goods yielding an 
income of direct satisfaction are normally distinguished by 
their owners from goods yielding a money return. The 
standards governing purchases of goods for business pur- 
poses are adequacy and sureness of return ; the standard 
governing purchases of goods serving personal uses is 
what one can afford. A home is seldom strictly a 
"business proposition," and for this reason may usually be 

192 



THE PRODUCTIVITY OF CAPITAL 193 

excluded from the rank of capital goods. And the same 
thing is true of other goods yielding an income, not of 
money, but of satisfaction. 

2. The permanent fund of productive wealth which capital 
goods represent is known as capital. 

The great majority of capital goods are perishable in 
their nature. The capital goods of a merchant, so far as 
they consist of merchandise, are destined in a very short 
time to pass into the hands of the merchant's customers, 
where they cease to be capital goods. So far as they 
consist of buildings and fixtures, they may endure a gener- 
ation or more; but in the end the buildings depreciate 
and the fixtures become antiquated. It would be next to 
impossible to find a business establishment which has the 
same capital goods it had a year ago. It is an easy 
matter to find an establishment which is said to have the 
same capital that it had a year ago. A merchant starts in 
business to-day with a capital of $100,000 invested in, 
building and stock. At the end of a year we ask him 
what his capital then is. Very likely it will still be 
$100,000. Now, is this the same capital, or is it a new 
one ? The merchant certainly will say that it is the same 
capital — unless, of course, he has lost, in the course of 
the year, his original capital and has replaced it from some 
new source. But how can the capital be the same after 
the lapse of a year ? Nearly all the things that figured in 
the first inventory except the building, have been replaced, 
in the second inventory, by objects which may be of a 
quite different character. In the first inventory, perhaps, 
cheap grades of goods preponderate ; in the second these 
may be largely replaced by higher grades. However this 
may be, there can be no denying that the goods have 
changed, yet the merchant says that the capital is the 
same. 

Perhaps we are making ourselves unnecessary difncul- 



194 INTRODUCTION TO ECONOMICS 

ties in our "endeavor to arrive at the merchant's meaning 
when he says that his capital remains the same even after 
most of the things originally composing it have left his pos- 
session. Possibly he means simply that he has as large a 
capital at one time as at another. Two things that are 
equal in magnitude are of course not the same thing, but 
we often speak of them as if they were. 

Yet if we reflect upon it, this does not appear to be what 
the business man means. Suppose that fire or flood had 
destroyed his store and stock, and that a rich relative, to 
set him on his feet again, had given him $100,000 to re- 
place them. The merchant would not say that he was 
continuing in business with the same capital, although in 
magnitude it would be the same. Clearly, a business man 
thinks of his capital as something that is capable of remain- 
ing permanently the same although the goods that compose 
it are constantly changing. The popular definition of 
capital is a fund of productive wealth, which has the power 
of self-perpetuation. This definition we may accept as one 
of the simplest that have been proposed. 

3. The permanence of capital depends upon the economic 
power of capital goods to replace their value either through 
sale or through assistance rendered in production. 

An enterpriser possessing $100,000 in cash proposes to 
establish a clothing store. The first thing he must do is to 
find a place where, he has reason to believe, the goods 
in which he proposes to deal will sell at a higher price 
than that which he must pay for them. This, of course, is 
comparatively easy to do. Goods, as they come from 
the factory, may in a physical sense be ready for use ; eco- 
nomically, however, much remains to be done before they 
can be placed where they will fulfil their ultimate purpose 
— the direct satisfaction of human wants. They must be 
conveyed to places where they are accessible to the con- 
sumer ; they must be so arranged that inspection is easy. 



THE PRODUCTIVITY OF CAPITAL 195 

Expert clerks must be at hand to point out their good quali- 
ties and explain away their bad ones. This means that a 
considerable addition to the value of goods may be made 
after they have left the factory ; and this addition, properly 
speaking, is the product of the mercantile establishment. 

Each item of the stock normally sells at a price which 
will at least replace that item with one of equal value, to- 
gether with a surplus which will cover the cost of labor 
employed in handling it, and which will also make some con- 
tribution to the expense of keeping up the building. Any 
item which does not do this is carried at a loss ; and a busi- 
ness man who should continue to carry such items would 
see his capital diminish, and perhaps ultimately disappear. 
Some parts of the stock may afford a far larger surplus, and 
the aggregate income of the establishment may be much 
more than enough to keep stock and store intact, after 
paying for all human services directly employed. The 
nature of this excess of income above outlay we shall con- 
sider at a later point. For the present we are concerned 
primarily with the fact . that the first demand upon the 
business is that each item shall maintain itself — i.e., 
through sale, reproduce itself together with auxiliary costs 
connected with it, 

It must now be clear how it is that a fund of capital 
persists. Each capital good, before it is sold or worn out, 
produces a sum of value that enables the owner of the good 
to purchase or make another good of the same character, 
which in its turn possesses the power of replacing itself by 
a successor of equal value. The capital goods of this year 
are, therefore, not merely the successors in time of those of 
last year, now mostly destroyed ; they are, economically, 
the offspring of the capital goods of the earlier period, and 
they have the same power of replacing themselves with 
other goods having the power of self-replacement. 

It is, of course, to be understood that this self-replace- 



196 INTRODUCTION TO ECONOMICS 

ment is neither automatic nor inevitable. We may say that 
under certain conditions a particular capital good will add 
something to the total product of an industry, but not enough 
to keep itself in repair and replace itself when worn out. 
Under other conditions a capital good will just do this; 
under still other conditions a capital good will add to the 
product of an establishment not only enough for its own 
repair and replacement, but a surplus besides. Experience 
has taught enterprisers how to avoid the employment of 
capital goods that do not maintain themselves, and of those 
that do nothing more than this. Mistakes are of course 
sometimes made, but not so frequently as to invalidate the 
statement that capital goods, as a rule, reproduce them- 
selves economically through the values which they create. 
Intelligent action on the part of the owner of such goods is 
essential to the truth of this proposition ; but such action 
may generally be taken for granted. 

4. What is capital to the individual may not be productive 
wealth from the point of view of society. 

A government may sell its bonds in order to raise funds 
to carry on a profitless war. The money raised is spent 
on powder and other munitions of war, which are soon 
destroyed. The wealth furnished by the purchasers of the 
bonds has simply been wasted, and cannot contribute to 
the payment of interest on the bonds or of the principal 
when it falls due. Interest and principal are, indeed, paid, 
but from the proceeds of taxation. The bondholder re- 
gards his bonds as capital ; they are wealth that yields an 
income, as he views the matter. But we can easily see 
that it is not the bonds that produce the income ; it is the 
labor and wealth employed in production that do this. If 
all the bonds were destroyed, the aggregate social income 
would be not in the least reduced. 

Capital of this kind may be called " purely acquisitive 
capital." It enables its holder to acquire an income ; it does 



THE PRODUCTIVITY OF CAPITAL 197 

not produce an income. Capital which actually participates 
in production may be called "productive capital." The 
laws which we shall discuss in this chapter relate only to 
productive capital. 

5. Productive capital may be embodied in goods that are 
the product of industry, or in goods that are the free gift of 
nature. 

A generation ago practically all economists restricted 
the term "capital" to productive wealth that has been pro- 
duced by industry, such as machines, stocks of materials, 
etc. Productive wealth, the origin of which cannot be 
traced to man's industry, was usually classified under the 
heading "natural agents," or simply under "land," since 
land is by far the most important good in this class. This 
terminology is still widely used by economists. In every- 
day language men speak of investing capital in land, as of 
investing capital in buildings or machinery. This usage 
will be followed in this book ; wherever it is necessary to 
distinguish between the two classes of productive wealth, 
we shall call the one artificial capital, the other natural 
capital. 

6. Artificial capital originates in saving. 

It may at first appear that capital comes into existence 
whenever a productive instrument is created. Reflection 
shows, however, that this cannot be true, for a new capi- 
tal good often merely replaces a capital good worn out in 
the process of production, and may be said to embody the 
same capital. 

When a man employs, in producing a tool or a stock of 
the materials of production, time which he would otherwise 
have used to procure for himself the means of immediate 
enjoyment, he is creating capital. These capital goods are 
not merely replacing capital goods previously existing; 
they are a net addition to the stock of productive wealth 
at the command of society, which, like other capital goods, 



198 INTRODUCTION TO ECONOMICS 

will for the future maintain themselves. When a man 
uses, to employ workmen in the production of capital 
goods, a part of his income which he would otherwise 
have spent for consumer's goods, he is causing new capi- 
tal to be created ; or, we may say, he is indirectly creat- 
ing capital. When he uses part of his income to buy 
capital goods that are already in existence, he is creating 
new capital by a still more indirect process. Thus if a 
man buys a threshing machine out of his savings, he 
places in the hands of the manufacturing company pur- 
chasing power with which the company can hire men to 
make another machine. The process of creating new 
capital may take a yet more roundabout course. The man 
who saves may invest his savings in a share of railway 
stock — which is nothing more than an evidence of owner- 
ship of capital goods already existing. The man who sells 
the share of stock may use the proceeds to buy a share in 
a manufacturing company. Here again it is evident that 
nothing new is created. The seller of the manufacturing 
stock may, however, use the money to buy a share in a 
new manufacturing company, and this company may em- 
ploy the proceeds to hire men to produce new capital 
goods for use in its business. Evidently it is the man 
who saved the money in the first instance who is the true 
creator of the capital thus added to the stock of society. 

Under present conditions the process of creating capi- 
tal is usually indirect. One man saves and other men 
produce the concrete capital goods in which the savings 
are invested. Of course it sometimes happens that such a 
complicated process fails to attain its proper end. One 
man may save $100 and buy a share of stock from another 
man, who uses the proceeds to meet his current expenses. 
In this case no new capital is created. What has hap- 
pened is that a part of the existing fund of capital has 
changed hands. But normally men avoid trenching upon 



THE PRODUCTIVITY OF CAPITAL 199 

their capital ; accordingly, we are justified in regarding 
each act of saving as the creation of new capital. 

Just as it is improper to regard the creation of a capital 
good as in itself a creation of capital, so it is improper to 
regard the destruction of a capital good through ordinary- 
use as the destruction of capital. For during its lifetime 
a capital good produces, as we have seen, a replacement 
fund. After the capital good has been destroyed, the 
capital exists under another form — as money or as other 
productive goods. 

7. Natural capital . increases with the development of 
society. 

Until the frontiersmen crossed the Appalachian Moun- 
tains, the land of the Mississippi Valley, with the timber 
upon it and the coal and other minerals beneath its surface, 
was scarcely to be classed as wealth at all. At best, it was 
potential wealth, not actual wealth. The settlement of the 
country and the development of means of communication 
transformed this potential wealth into an immense fund of 
productive wealth, or capital. Every increase in popula- 
tion, every improvement in methods of agricultural produc- 
tion, increases the importance, and with it the value, of the 
natural resources of a country. Measuring the capital rep- 
resented by these natural resources in terms of value, we 
see that it is constantly growing with the progress of 
society. The introduction of durum wheat raised the capi- 
tal value of lands in part of the arid belt from practically 
nothing to $10 an acre or more. The development of a 
spineless cactus may transform into productive wealth 
much of the desert land of the Southwest. New processes 
of steel manufacture have endowed iron ore deposits origi- 
nally worth very little with the character of highly produc- 
tive capital. 

8. The productivity of a capital good can be ascertained 
only through experimentation. 



200 INTRODUCTION TO ECONOMICS 

In order that a business man may conduct his business 
successfully, he must be able to form a fairly accurate esti- 
mate of the productivity of each class of capital goods 
which he uses. In the case of some classes of capital 
goods productivity is easily determined. Thus if one 
wishes to know how much a ton of fertilizer will produce, 
he has only to apply it to one of two equally productive 
acres of ground. The difference in the product of the two 
acres, less the cost of labor employed in applying the 
fertilizer, is a fair test of the productivity of a ton of ferti- 
lizer. We may term this the gross .product of the capital 
good. After deducting from this product a sum equal to 
the cost of the fertilizer, whatever remains is the net prod- 
uct of the capital good. 

Some capital goods, however, do not readily admit of 
any such process of experimentation. Thus it might be 
difficult to determine the productivity of a field, apart from 
that of the seed, fertilizer, machinery, and labor employed 
in connection with it. Of course one acre might be left 
untilled, and all the labor and auxiliary capital might be 
employed on the rest of the field. The total product 
would be less than it would have been had all the field 
been tilled ; and this diminution in product would indicate 
roughly the productivity of an acre of ground. This 
method would be clumsy and expensive; it is, moreover, 
unnecessary, since the productivity of labor and of auxiliary 
capital employed upon the land may be determined, for 
the most part, by the method already illustrated. Hence 
we may arrive at the gross product of the field by subtract- 
ing from the total product of the farm the values produced 
by the labor and the auxiliary capital. By subtracting from 
the gross product of the land a sum of value sufficient to 
replace the elements of fertility destroyed in the course of 
the year, we arrive at the net product of the land. 

9. The net product of capital goods is commonly known as 
the product of capital. 



THE PRODUCTIVITY OF CAPITAL 201 

Capital goods obviously must vary widely in their gross 
product. Some must be replaced daily, some yearly, some 
at the expiration of a decade or more ; a few classes, like 
land, are practically permanent. Until full replacement of 
goods used up has been made, a fund of productive wealth, 
or capital, cannot be said to be productive. A manufac- 
turer who finds that the receipts from a year's business are 
just sufficient to maintain intact his building, machinery, 
stock of material, and fuel, cannot say that his capital has 
added anything to his income. Capital which produces 
nothing is obviously not worth having ; and the mere fact 
that men make sacrifices to possess themselves of capital 
shows that, as a rule, capital may be expected to yield an 
income. 

When a man is considering whether he shall invest his 
capital in one kind of capital goods or in another, he may 
usually .take the fact of self-replacement of goods for 
granted. The net productivity of capital goods, or, to use 
a simpler term, the product of capital, is the determining 
factor in his calculations. 

10. The productivity of capital invested in any one class 
of goods is measured by the addition made to product by the 
last or marginal unit of capital thus invested. Other things 
equal, the productivity of capital in any one form shrinks 
with increase of capital in that form. 

Let us suppose that a farmer possesses ten fields, vary- 
ing in natural fertility from a very high degree to a very 
low degree. And let us assume that $1000 worth of 
capital in the form of machinery, stock, etc., or auxiliary 
capital, is necessary for the tillage of any one of the ten 
fields. 

If the farmer has control over only $1000 worth of 
auxiliary capital, he will of course place it upon the best 
field. If from the gross product of that field he deducts 
the cost of labor employed in connection with it, together 



202 INTRODUCTION TO ECONOMICS 

with a sum sufficient to cover the cost of upkeep of land 
and stock, he arrives at the net product of his agricultural 
capital — that is, of capital invested in both fields and 
stock. How much is due to the bare land, how much to 
the auxiliary capital? This it would be difficult to say, as 
neither would have produced anything without the other. 

Now let us suppose that the farmer gets possession of 
another $1000 to invest in auxiliary capital. He may now 
till the field which is least inferior to the first one cultivated. 
The joint product of this field and of the $1000 of capital 
will be less than that of the first field because of the differ- 
ence in natural fertility. Shall we say that $1000 is more 
productive on one field than on the other ? The two units 
of capital are just alike; the two fields are unlike. So it 
would seem to be more reasonable to assign the difference 
in productivity to the fields, not to the auxiliary capital. 
And this is what a practical man would do. If the first 
field produces $1000 and the second $900, he would say 
that at least $100 of the product of the first is the product 
of the land, apart from that of the auxiliary capital. 

Is the $900 produced on the second field the product of 
the auxiliary capital alone ? In a physical sense, certainly 
not ; in an economic sense it is. This sum is what the addi- 
tional $1000 worth of auxiliary capital adds to the farmer's 
income ; $900 is what he would lose if he were deprived 
of either of his two units of capital. 

With another $1000 the farmer is enabled to till a third 
field, which is somewhat less fertile than the second. Per- 
haps this field produces $800 net. If this is the case, the 
farmer will no longer regard the total product of the second 
field as the product of the auxiliary capital alone. This 
auxiliary capital is credited with no larger product than 
that of auxiliary capital on the third field — $800. The 
other $100 now comes to be considered as the product of 
the land. At the same time, of course, a second $100 is 



THE PRODUCTIVITY OF CAPITAL 203 

subtracted from the product of auxiliary capital on the best 
grade of land. And as the farmer adds unit after unit of 
auxiliary capital and opens field after field to tillage, the 
productivity of auxiliary capital steadily shrinks and that 
of the better land as steadily increases. Perhaps the tenth 
field yields a net return of only $100. In such case no 
one of the ten units of auxiliary capital can be said to yield 
more than this. The use of no one of the units is worth 
more to the farmer than $100, for if any one were taken 
away from his control, he would replace it with the one 
employed in connection with the poorest field. 

In a grist mill the amount of capital which may be in- 
vested in machinery varies within wide limits. Once the 
mill is equipped with machinery, it would be difficult to 
increase greatly the amount of capital invested in machin- 
ery, since not more machines, but better ones, would here 
be the result of increased investment. We may, however, 
suppose that in determining upon the kind of equipment 
to be employed, an enterpriser goes through some such 
calculation as the following : — 

Given a building and a certain minimum of auxiliary 
capital invested in machinery — say $10,000, an annual 
return of $10,000 may be secured. How much of this is 
the product of the building ? how much is the product of 
the machinery ? No one can say ; neither form of capital 
would produce anything without the other. Increase the 
capital in machinery by another $10,000 unit; the net 
return increases, we will say, to $15,000. The sum added 
by the second unit of auxiliary capital is $5000; as the 
two units of auxiliary capital are interchangeable, neither 
will be credited with more than this. Thus $5000 de- 
taches itself from the joint product of building and ma- 
chinery, and is credited to the building. Add another 
$10,000 unit in the form of machinery. The return in- 
creases to $17,000. $2000, then, is the product that can 



204 INTRODUCTION TO ECONOMICS 

be credited to this unit of auxiliary capital, and no one of 
the three units will be credited with more than this. The 
building thus conies to be credited with $11,000, the sum 
remaining after the product of the three units of auxiliary 
capital has been deducted. 

The principle involved in this example may be stated 
as follows : The productivity of any unit of capital em- 
bodied in a given class of capital goods is measured by 
the amount added to the aggregate net product of a 
business by that unit which it is least worth while to 
employ. 

11. An increase in the capital of any establishment, at- 
tended by no parallel increase in labor, reduces the produc- 
tivity of capital and increases that of labor. 

Suppose that a farmer can command practically an in- 
definite amount of agricultural capital, whether in the 
form of land or in the form of movable capital goods, but 
that the amount of labor that he can secure is limited to 
ten men. With $5000 invested partly in land, partly in 
movable capital goods, he may be able to produce $5000 
net. We should here find difficulty in determining what 
part of this sum is produced by the labor, what part by 
the capital. An additional $5000 of capital may increase 
the aggregate product of the business by $4000. This 
sum we should properly ascribe to the new capital. And 
as this second unit of capital does not differ in any essen- 
tial respect from the unit at first employed, and as the 
removal of one unit of the two would have the same effect 
as the removal of the other, we may properly regard them 
as equally productive. The extra thousand appearing in 
connection with the first unit must then be credited to the 
other factor in production — the labor. If a third unit of 
capital increases the product of the business by $3000, 
this amount will measure the importance of any one of the 
three units of capital. This is what the farmer would lose 



THE PRODUCTIVITY OF CAPITAL 205 

if he were deprived of the use of any of the units. If a 
fifth unit adds only $1000, the product assignable to any 
unit shrinks to that figure. And of course with each re- 
duction in the product assignable to capital, the product 
assignable to labor increases. 

12. If the capital of an industry, or the capital of all soci- 
ety, increases, the productivity of capital declines. 

Up to the present point our study of the productivity of 
capital has been confined to the single business establish- 
ment. We must now consider whether similar principles 
are applicable to an industry in its entirety. The iron and 
steel industry of the United States may serve as our type. 

The capital at present engaged in the production of iron 
and steel may # be placed at about $1,000,000,000, the number 
of men, at 250,000. Now let us suppose that without any 
revolutionary change in the demand for iron and steel the 
capital of the industry is increased by $100,000,000. What 
will be the effect upon the productivity of capital in the 
industry ? 

It is fair to assume that before the increase in capital 
those branches of the industry promising the highest prof- 
its were already well developed ; that the richest deposits 
of ore and coking coal were already being exploited ; that 
the best manufacturing sites had been selected. To what 
use, then, will the new capital be put ? Some of the enter- 
prisers may attempt to duplicate existing plant. This re- 
quires additional labor, and such labor is to be had only 
by inducing new men to enter the industry or by enticing 
men away from other iron manufacturers. In either case an 
advance in wages will follow, which will soon become gen- 
eral throughout the industry. In the old establishments as 
well as the new this will obviously reduce the share of the 
aggregate product which capital will receive. Again, the in- 
crease in iron and steel products thrown upon the market 
will lower prices. Thus, while the wages bill of an estab- 



206 INTRODUCTION TO ECONOMICS 

lishment per unit of product will increase, the value of 
each unit of product will diminish. 

If all the new capital is used simply to duplicate existing 
plant, wages will rise to a decidedly higher level. The in- 
dustry will need one tenth more men than it has at present, 
and these will be slow to appear unless they are offered 
high wages. The fall in prices, moreover, will be a serious 
one, as the output will be increased about ten per cent. 
But when the prices of the staple products of an industry 
fall, it often pays to develop new branches of the industry 
that under earlier conditions were not profitable. When 
wages rise, it pays to introduce machinery that saves labor. 
Part of the new capital will be absorbed in these ways, and 
thus the productivity of capital will be prevented from 
sinking to as low a level as would otherwise be the ease. 
The fact remains that the capital will be less productive 
after the increase than before it; wages will be higher 
and prices lower. The increase in the aggregate capital 
of the industry, other things equal, will reduce the produc- 
tivity of each unit. 

The same principle is still more clearly applicable to in- 
dustrial society as a whole. The iron and steel industry 
can relieve the pressure upon its labor supply by inducing 
men to leave other industries. If the capital of society as 
a whole increases, a pressure is placed upon the labor sup- 
ply, for which there is no ready means of relief. The exist- 
ing capital is normally sufficient to provide every one who 
desires to work with the necessary appliances. If, then, 
the capital of all industries increases more rapidly than 
the population, the average capital employed with each 
laborer must increase. Such increase in capital must be 
embodied in improvements upon existing appliances, and, 
owing to the operation of the law of diminishing returns, 
will increase the product of industry less than an equal 
amount of capital does when the social fund is smaller. 



THE PRODUCTIVITY OF CAPITAL 



207 



13. The opening of new opportunities for investment may 
counteract the effect of increase i7i capital. 

There are of course conditions under which an increase 
in capital may not be followed by a reduction in the prod- 
uctivity of capital. If, for example, the labor supply in- 
creases as rapidly as the supply of capital, there is no 
reason why the productivity of capital should decline. 
Again, suppose that some practical method of draining 
extensive swampy regions or of irrigating vast tracts of 
arid land were discovered. The new capital might be 
absorbed by the opening of these fields. In the last 
century, though capital has increased enormously, there 
has been a corresponding enlargement of the field of in- 
vestment ; accordingly, the productivity of capital has de- 
clined little, if at all. 

14. An increase in artificial capital, while reducing 
returns on that form of capital, is likely to increase the 
returns from natural capital. 

It has already been indicated that by placing more and 
more auxiliary capital upon a given area of land one must 
ordinarily reduce the productivity of auxiliary capital and 
increase the productivity of land. It will naturally be the 
aim of the business man to keep his capital uniformly pro- 
ductive ; if he has too much auxiliary capital he will en- 
deavor to get more land, and vice versa. He will ask 
himself: Would it pay me better to invest my next $1000 
in land or in auxiliary capital ? And he will continue to 
direct his investments toward whichever class of capital 
goods is for the moment the more productive, until the 
superiority of that class disappears. 

Similarly, an entire industry may expand with more or 
less symmetry, distributing its new capital among the 
various classes of capital goods of which it stands in need. 
If the beet sugar industry expands, not only are more 
factories constructed, more machinery for the cultivation 



2o8 INTRODUCTION TO ECONOMICS 

of beets purchased, but more land is drawn into the service 
of the industry. This land is, of course, taken away from 
other industries — wheat culture, dairying, etc. 

When the social fund of capital increases, on the other 
hand, it is not possible for a symmetrical increase in all 
classes of capital to take place. The land, we may sup- 
pose, is already almost all in use ; the best mines are 
opened ; the most available courses for railways and canals 
are already occupied. These things the new capital can- 
not duplicate; their importance, therefore, steadily increases. 
On the other hand, steel rails, locomotives, factory build- 
ings and thousands of other forms of capital goods are 
readily duplicated. The marginal productivity of capital 
in these forms naturally declines, and a larger part of the 
product is left to be divided between labor and natural 
capital. 

15. When the return to natural capital varies from the 
return to artificial capital, equalization is commonly brought 
about by revaluation. 

When, however, we speak of the productivity of capital 
in general we usually take as our test the productivity of 
new capital — . and this, we see, is practically the capital in 
goods which are capable of duplication. And instead of 
thinking of the old capital in nonduplicable goods as more 
than normally productive, we are likely to revalue the 
capital in such forms. Ten years ago, let us say, a five- 
acre lot gave as large a net product as a threshing machine. 
To-day the same piece of land yields twice as large a net 
return as a threshing machine equal in value to the one of 
ten years ago. We might say that the capital in land has 
doubled in productivity. But it is more usual to say that 
to-day the land represents twice as much capital as the 
threshing machine, although it represented no more capital 
than the threshing machine ten years ago. By a similar 
process of revaluation, the productivity of all capital which 



THE PRODUCTIVITY OF CAPITAL 209 

is abnormally productive is reduced to the general level. 
This process of revaluation will receive our further atten- 
tion in the next chapter. 

16. The productivity of artificial capital varies at any 
particular time from industry to industry, but tends con- 
stantly toward a uniform level. 

Even capital which is embodied in capital goods that 
are capable of reduplication may at any given time vary 
widely in productivity from establishment to establishment, 
or from industry to industry. It is only by experimentation 
that the actual productivity of capital can- be determined, 
and owing to the changing character of modern industry 
the process of experimentation must go on without ceasing. 
Accordingly, there are always chances of mistakes in invest- 
ments. A cotton manufacturer may overestimate the prod- 
uctivity of capital in a given type of loom ; after purchasing 
and installing the machine he must content himself with 
what it will produce, even though he knows that the same 
amount of capital would in another form yield a far higher 
return. Cotton manufacturers as a class may overestimate 
the future demand for cotton goods, and so may be led to 
invest heavily in buildings and machinery which prove in- 
capable of returning the normal rate of interest on capital. 
At the same time the shoe industry may be undersupplied 
with capital ; for a time, at least, every one hundred dollars 
invested in the industry may yield an abnormally high 
return. 

Such disparity in the productivity of capital in the two 
industries would, however, tend to disappear. The capital 
invested in new cotton mills would, of course, be fixed in the 
industry for a long period of time. But in the industry as 
a whole there are always some mills that are about to be dis- 
mantled, having reached the limit of their useful existence. 
These mills have presumably earned in the past a sum suffi- 
cient to replace themselves with new mills of a value equal 



210 INTRODUCTION TO ECONOMICS 

to that of the original ones. If the cotton industry is suf- 
fering from a depression while the shoe industry is highly 
prosperous, the replacement fund will be diverted to the 
latter industry. Through the reduction of capital in the 
cotton industry the productivity of capital in that field is 
increased ; through the increase of capital in the shoe indus- 
try the productivity of capital is reduced in that industry. 
It is easy to see that if this process continues for any 
length of time the original disparity in productivity must 
disappear. 

The equalization of productivity is hastened by the dis- 
position of new accumulations of capital. The fund of 
capital, under modern conditions, is constantly growing in 
magnitude ; consequently industries are, as a rule, expand- 
ing. The new capital naturally seeks the most productive 
fields. If, therefore, the rate of return in the cotton indus- 
try is abnormally low while that in the shoe industry is 
abnormally high, the new capital will avoid the former 
industry and seek investment in the latter. The influx of 
new capital into the shoe industry reduces productivity 
there, until at last capital is no more productive in the one 
industry than in the other. When this point has been 
reached, further additions to the supply of capital are 
divided impartially between the two industries, reducing 
productivity uniformly. 

It is, of course, possible that the productivity of capital 
in the two industries may never be absolutely equal. 
While the tide of new capital is setting steadily toward 
the shoe industry, a new demand for cotton goods or a 
new method of manufacture may appear and raise the 
productivity of capital in the cotton industry above that of 
the shoe industry. Some time will elapse before the 
change in the relative positions of the two industries is 
generally known ; in the meantime the flow of new capi- 
tal into the shoe industry continues. Eventually the new 



THE PRODUCTIVITY OF CAPITAL 211 

capital is diverted to the cotton industry ; it may continue 
to flow in that direction after the cotton industry has lost 
its relative superiority. We can only say that a tendency 
toward equalization of productivity exists ; not that equali- 
zation is ever exactly realized. 

17. Any barrier preventing the free flow of capital into 
an industry makes possible an abnormally high return on 
capital in that industry. 

It is, of course, to be remembered that the productivity 
of capital is not the only thing that an investor takes into 
account in deciding in what industry he shall invest his 
savings. In some investments the danger of losing all or 
a part of the capital invested is great. Capital employed 
in developing the asphalt deposits of Venezuela may be 
highly productive ; but there is a chance that the existing 
government of Venezuela, from which title to the asphalt 
deposits is derived, may be overturned, and a new govern- 
ment may confiscate the capital invested in the business. 
Capital invested in street railways may be very productive. 
But if cities do not follow a consistent policy in chartering 
new cqmpanies, it is possible that at any time rival lines 
may be established on parallel streets and, if unable to 
make large returns themselves, they may, nevertheless, 
reduce the return on capital invested in the original lines 
to almost nothing. The capital still remains in the pos- 
session of the investor, but it is "dead capital." A mer- 
chant's capital, invested in a fancy fabric, may promise 
high returns; but a sudden change in fashion may force 
the merchant to sell the goods at a price which not only 
yields no return on the capital invested, but which entails 
an actual impairment of the capital fund itself. 

Some risk, it is plain, inheres in every business; in 
some fields of investment, however, the risk is so small as 
to be negligible, while in other fields no prudent investor 
can disregard it. Other things equal, the vast majority of 



212 INTRODUCTION TO ECONOMICS 

investors will prefer to invest in the safer fields. A dis- 
proportionately large share of the capital of society, there- 
fore, seeks the safer investments, and as a result the 
productivity of capital in such investments falls below the 
rate of return to capital in the more hazardous investments. 
And thus it is that there appears a regular variation in the 
productivity of capital corresponding with variations in 
risk. 

It is, of course, clear that it is not actual risk, but esti- 
mated risk, that affects the distribution and hence the prod- 
uctivity of capital. It is quite possible that the risk of los- 
ing capital invested in banking in Texas is less than the risk 
of losing capital similarly invested in New York. But if 
most of the persons having capital to invest mistakenly 
believe that the reverse is true, a disproportionately large 
part of the flow of new capital will enter the New York in- 
vestment field and reduce the productivity of capital there 
below the level prevailing in Texas. 

In an earlier chapter we saw that risk affects wages 
only in so far as it affects the distribution of labor ; further, 
that if enough reckless workmen can be found to man the 
dangerous trades, risk will not affect wages at all. Exactly 
the same thing is true of capital. If there were enough 
investors who always chose the more remunerative employ- 
ments for capital, regardless of risk, the hazardous fields 
would soon be so well supplied with capital that they would 
yield no higher returns than the safer ones. As a rule, how- 
ever, capital is far more timid in assuming risks than labor. 
It is therefore more anomalous to find capital in a haz- 
ardous field yielding only normal returns than it is to 
find workmen in dangerous occupations receiving only 
normal wages. 

Risk, then, may be regarded as a barrier which .pre- 
vents capital from flowing freely into some of the more 
productive fields. It is of course not the only natural bar- 



THE PRODUCTIVITY OF CAPITAL 213 

rier affecting the flow of capital. If a particular industry is 
subject to the universal moral disapproval of a community, 
most capitalists will refuse to invest in it. Those who are 
unscrupulous enough to do so may enjoy the high returns 
that flow from an industry that is under-supplied with capi- 
tal. Thus, high returns are often obtained from capital 
invested in gambling dens and opium "joints." It is, of 
course, possible that the investment institutions of a country 
may be of such a nature that a man can hold stock in dis- 
reputable enterprises without the knowledge of his associ- 
ates, and that investors who have no personal scruples are 
numerous. Under these conditions the productivity of capi- 
tal in such ventures will eventually fall to the normal level. 

18. Summary. 

Material goods which serve as means of production are 
known as capital goods. In the normal course of industry, 
each capital good, before it is worn out, makes at least a 
sufficient addition to product to replace itself with an equally 
valuable capital good ; and under normal conditions, each 
capital good, when worn out, is actually replaced. Capital 
goods may therefore be regarded as a self-perpetuating 
fund of productive wealth. This fund is termed productive 
capital ; it is to be distinguished from those forms of wealth, 
also commonly termed capital, which add nothing to the 
product of society, although they enable their owners to 
secure an income. Under certain conditions, it is necessary 
to distinguish between that productive capital which is the 
product of industry and that which is the free gift of na- 
ture. The former may be termed artificial, the latter 
natural, capital. 

The productivity of each capital good can be ascer- 
tained only through experimentation. A distinction must 
be made between the gross product of a capital good — the 
total value product originating in it — and its net product 
— the sum of value remaining after deduction of the ex- 



214 INTRODUCTION TO ECONOMICS 

pense of repairs or replacement. The net product of capi- 
tal goods may be regarded as the product of the fund of 
such goods, or capital. 

The productivity of capital invested in any class of goods 
is determined by the addition to net product made by those 
goods of the class that perform the least important func- 
tions. Every increase in the amount of capital invested in 
a given class of goods tends to reduce the productivity of 
each unit of capital in that class, and to raise the produc- 
tivity of capital invested in other classes of goods, as well 
as the productivity of labor. Natural capital often fails to 
increase as rapidly as artificial capital; consequently, for 
long periods of time the productivity of natural capital 
goods tends to increase, while that of artificial capital goods 
tends to decline. Equalization of return to the two classes 
of capital can be brought about only through revaluation 
of the natural capital goods. The earnings of capital in 
the different classes of artificial capital goods tend, under 
competition, toward a uniform level; in many cases, how- 
ever, barriers preventing the free flow of capital keep the 
earnings of capital in one field permanently higher than 
in another. 



CHAPTER XIII 
RENT, INTEREST, AND CAPITALIZATION 

1. Rent, in everyday speech, is a payment for the tempo- 
rary use of durable goods. 

In popular usage the term "rent" is applied to any pay- 
ment which one person makes to another for the tem- 
porary use of a concrete good or group of goods. Thus 
rent may be paid for the use of a farm, a house, a piano, a 
square yard of advertising space on a bill board. In the 
nature of the case, only those things can be rented which 
remain practically intact through the period of use. One 
never rents a bin of coal or a stock of merchandise. Nor 
does one ever rent goods which can serve their purpose 
only by entering into permanent combination with other 
goods. No one would think of trying to rent steel beams 
to be used in the construction of his house. The more 
nearly indestructible a good is, and the more perfectly it 
yields up its services without losing its identity, the better 
is it adapted to the renting contract. Thus a field, being 
practically indestructible, may very well be rented for a 
period of years, although if its cultivation requires the in- 
corporation of a large amount of auxiliary capital in the 
soil, in the form of drains or irrigation ditches, the field and 
the auxiliary capital must usually be rented together. A 
piano, which is much more likely to be injured, neverthe- 
less lends itself fairly well to the renting contract because 
no other capital good enters into permanent combination 
with it in use. 

2. The term rent has been commonly used by economists to 
designate income arising from natural agents. 

In the classical economic terminology, rent included all 
income from permanent natural agents, whether these 

215 



216 INTRODUCTION TO ECONOMICS 

agents were leased or employed in production by their 
owners. A field, a building site, or a waterfall, it was said, 
yields rent. Incomes from houses, machines, and other 
reproducible goods were called interest on capital. The 
word rent is used in the classical sense by a large number 
of our living^ economists. While the term will be given a 
different meaning in this book, we shall recognize rent in 
the traditional sense under the name ground rent. 

3. The term rent in its broadest sense includes the prod- 
ucts of all capital goods, whether rented by the enterpriser 
or owned by him. 

If a man owns and manages a farm which he could let at 
a rental of $1000, we may say that $1000 out of his income 
is really the rent of his farm. True, he does not pay this 
sum to any one ; but neither does he pay any one wages for 
the labor which he himself performs. It would be absurd, 
however, to say that a man earns no wages when he is work- 
ing for himself. As employer he pays himself wages as 
workman. In like manner, the man who cultivates his own 
field may be thought of as paying rent, as cultivator, to him- 
self, as landlord. So, if an ocean transportation company 
owns and sails a ship which it could let for $5000 a year, we 
may regard $5000 out of the proceeds of the company's 
business as the rent of this particular ship. In this broad 
sense of the term, rent may be defined as that part of the 
proceeds of a business which is economically due to a par- 
ticular capital good. It is the economic product of a capi- 
tal good, regarded as a lump sum. And as even the most 
perishable of capital goods yield a product which may be 
measured in this way, we may strain the ordinary meaning 
of the term rent so as to include the concrete products of 
all capital goods whatsoever. 

4. For practical reasons, a study of rent may best be con- 
fined to the products of goods that have a high degree of 
permanence. 



RENT, INTEREST, AND CAPITALIZATION 217 

While the term rent is, as has been said, properly ap- 
plied to the product of any concrete capital good, we shall 
in this chapter confine our study to the rent of those classes 
of goods that are of such a nature as to permit the trans- 
fer of their uses under renting contracts. The distinguish- 
ing characteristic of this class of goods is that the capital 
embodied in them is fixed there, for a considerable period of 
time at least. It takes. perhaps ten years before the capi- 
tal invested in a boat can migrate to some industry upon 
the dry land. The capital embodied in a well-built house 
may be fixed there for fifty years ; and the capital invested 
in a field, in a tunnel, or in an excavation must remain where 
it is forever. It is true that you may take your capital out 
of a field ; this you do when you sell it. But what you 
really do when you sell the field is to transfer to another 
person your claim to the capital it represents. The capital 
in the field is the same after the transaction as it was before 
it. Such permanently invested capital may be contrasted 
with the capital invested in transitory forms, as coal, raw 
materials, merchants' stocks. The capital invested in these 
forms returns to its owner in a relatively short time in the 
form of purchasing power, and may be reinvested in any 
one out of a thousand different classes of capital goods. 
The return to such transitory goods is most conveniently 
calculated as a percentage return to the capital invested in 
them. It is natural to think of the return to a farm or a 
building as a certain sum of money, or a rent. One may, of 
course, translate the rent into terms of interest on the capi- 
tal invested in the farm or building. On the other hand, 
it is natural to think of the return to a merchant's stock in 
trade as interest on the capital invested in the stock, al- 
though it would be quite possible to arrive at the returns to 
the stock by adding together the net products of all the 
capital goods whose services have been used. 

5. Gross rent is the total product of a capital good ; net 



218 INTRODUCTION TO ECONOMICS 

rent is whatever remains of the product after deductions have 
been made for the repair and replacement of the capital 
good. Net rent is identical with interest. 

We must be careful to distinguish between the total prod- 
uct of a capital good, or its gross rent, and that part of 
the product remaining after the cost of depreciation of the 
capital good has been deducted, or net rent. To arrive at 
the net rent of a house we must deduct from the gross rent 
a sum sufficient to meet the cost of repairs, together with a 
year's proper contribution to a fund for the replacement of 
the house when it shall cease to be habitable. Even the 
payment for the use of a field is a gross rent. The field 
wears out — that is, it loses through cropping a part of its 
original or acquired fertility. The owner of the field must, 
therefore, set aside a part of the product of the land to re- 
store the fertility of the soil. 

It will be noted that net rent, in the sense in which the 
term is used here, is nothing but interest under another 
form. We will say that a house yields a net rent of $1000. 
This $1000 is the sum of interest on the capital invested in 
the house. If this capital is $10,000, each $100 of it yields 
an income of $10. In other words, the rate of interest is 
ten per cent. In general, if we reduce the rent of a group 
of capital goods to a percentage of the capital embodied in 
them, what we have is interest on this capital. 

6. The rent of the permanent goods used in an enterprise 
is most conveniently treated as a residue remaining after the 
wages of labor \ charges for the use of capital in perishable 
forms, and the cost of materials and other perishable 
goods have been deducted from the total product of the 
enterprise. 

In the last chapter we saw that there are two ways of 
arriving at the product of a concrete capital good, or its 
rent. One way is to withdraw the capital good from the 
productive combination into which it enters, noting the 



RENT, INTEREST, AND CAPITALIZATION 219 

shrinkage in product that follows. The other way is to 
deduct from the gross receipts from a group of several 
goods the shares (if these can be independently ascertained) 
that are due to all of the goods except one. What is left 
is of course the product or rent of the remaining good. 
Either method may be employed in ascertaining the rent 
of many capital goods ; but the latter method is most fre- 
quently employed in the case of goods that lend themselves 
readily to the renting contract. If one wishes to rent a 
steam thresher, for example, he will first of all inquire what 
the gross earnings from the operation of the machine are 
likely to be. Perhaps such'earnings will average $20 a day. 
In order to operate the thresher, it is, of course, necessary 
to employ labor and auxiliary capital goods — as coal and 
machine oil — in connection with it. The labor must be 
paid for at the prevailing rate of wages ; coal and oil must 
be paid for at the market price. There are accordingly defi- 
nite sums that must be deducted from the gross receipts 
from the operation of the machine. Whatever is left after 
these charges have been met — possibly $10 — is the gross 
rent of the machine for the day. 

In the foregoing example the cost of labor, of coal, and of 
oil were regarded as preferred charges upon the earnings 
of the enterprise, and this indeed they are. The operator 
of the threshing machine must pay at least the prevailing 
rate of wages, or he cannot get labor to run the machine. 
Similarly, he must pay the market price of coal. Labor 
and coal have a multitude of uses outside of the business 
of threshing ; if not properly rewarded in that busi- 
ness they go elsewhere. The machine, on the other hand, 
cannot seek other employment. It is committed to a par- 
ticular function ; consequently it cannot enforce any claim 
for a specific remuneration. The machine is, as it were, a 
residuary claimant; and this is more or less true of most 
of the capital goods that are actually rented. Economists 



220 INTRODUCTION TO ECONOMICS 

therefore find it convenient to treat rent as though it were 
always determined in this way. 

A steamship building company, not having sufficient 
orders on hand, launches a freighter on its own account, 
trusting to the chance that some ocean transportation com- 
pany will be ready to pay a fair rental for its use. What 
will determine the rent that the transportation company 
will offer to pay? The managers of that company can 
probably estimate pretty accurately what the gross receipts 
from a year's operation of such a ship would be. Let us 
say that the estimated gross receipts are $35,000. From 
this sum must be deducted the wages of officers and men, 
$7000; charges for pilotage, harbor dues, etc., $1000; 
the cost of coal and provisions, $10,000; miscellaneous 
expenses, $1000. Nor is this quite all. The $10,000 in- 
vested in coal and provisions — supposing that the trans- 
portation company must purchase the whole amount at 
the beginning of the year — is capital that would in any 
other field earn $500 interest. This sum must therefore 
be added to the preferred charges of operating the ship. 
The $15,500 remaining out of the estimated gross receipts 
is the maximum rent that the transportation company can 
pay for the use of the ship. This sum, the gross rent of 
the ship, includes, however, payment for the depreciation 
of the ship through one year's use. If this amounts to 
$10,000, we have remaining the sum of $5500 as the net 
rent. 

Similarly, the gross rent of a farm is found by deducting 
from gross receipts a sum that is sufficient to pay the wages 
of all labor employed in cultivating it ; to replace all capi- 
tal goods used up ; to keep up the efficiency of all stock 
and machinery, together with interest at the prevailing rate 
on the capital invested in such movable capital goods. 
To arrive at the net rent we must deduct from the gross 
rent thus determined whatever may be necessary to keep 



RENT, INTEREST, AND CAPITALIZATION 221 

buildings, fences, etc., in repair, and to restore to the soil 
any elements of fertility that have been destroyed in the 
year's cropping. 

7. The rent of any one out of a number of classes of goods 
united in a permanent combination may be ascertained by 
comparison with other productive combinations in which 
some, but not all, classes are represented. 

In the cases that have been given the rent-yielding ob- 
ject is a group of capital goods, more or less securely 
bound together in use. The farm, for example, may be 
analyzed into several distinct factors. One factor is the 
bare land ; another factor consists of improvements merged 
in the soil, as drains or irrigation ditches ; a third factor 
consists of farm buildings, fences, tree plantations, etc. 
Some part of the rent must be ascribable to each one of 
these factors. The productivity of such a factor cannot be 
found by withdrawing it ; nor can it be found by treating 
it as a residue, after ascertaining the shares of the other 
factors combined with it, for these shares cannot be ascer- 
tained directly. There remains the method of compari- 
sons. How much more will a well-drained field yield than 
another field in the vicinity, of apparently equal natural 
fertility, but without drains ? By such comparisons it is 
usually possible to tell pretty nearly what each factor in 
a permanent combination of capital goods is producing. 
One may distinguish in this way between the rent paid 
for a city house and the rent paid for the ground it stands 
on, although the two rents usually make parts of a single 
payment. Find an equally spacious and costly house in 
a suburb, where a building lot is to be had for practically 
nothing. The difference in the rent of the two houses 
is a fairly accurate measure of the rent of the city lot. 

8. The rent of an artificial capital good tends, in the long 
run, to equal interest, at the current rate, on the cost of du- 
plicating the capital good. 



222 INTRODUCTION TO ECONOMICS 

The rent of a ship, a building, or a machine, may, as we 
have seen, be ascertained, in the first instance, by subtract- 
ing from the gross receipts arising from its operation a sum 
covering all other expenses connected with its use. The 
value of such a rent-bearing object does not immediately 
affect the amount of rent it yields. A ship that yields a net 
surplus of $5000 above operating expenses may be worth 
$50,000 or $100,000. The value of the ship has nothing to 
do with the amount of rent that its owner will receive in 
the immediate future. But a ship is a capital good that 
requires periodic renewal. Out of 1000 ships sailing the 
ocean to-day probably fifty are near the end of their eco- 
nomic existence, and will have to be replaced by new ships 
if the existing tonnage is to be maintained. Now, if the 
rent of ships happens to be so low as not to pay the 
ordinary rate of interest on the capital represented by 
the cost of building them, no new ships will be built 
to take the places of those that are no longer seaworthy. 
The aggregate tonnage will thus be reduced ; freights will 
be advanced until the rent of ships rises to a figure which 
affords a normal return to shipping capital. If, on the 
other hand, the rent of ships represents an abnormally 
high return to capital, more ships will be built, and freights 
will decline until the rent of ships is only sufficient to pay 
a fair rate of interest on the capital invested in them. And 
this is in general true of the rents of all capital goods re- 
quiring periodic renewal. For a time the rent may be too 
high or too low to afford just a normal return to the capi- 
tal invested in such goods. In the long run, however, the 
rent is controlled by the prevailing rate of interest. 

9. The rent of land is dependent > in large measure , upon 
the rate of wages and of interest on auxiliary capital. 

We have seen how it is possible to distinguish the rent 
of the bare land from the rent of the improvements fixed in 
it. The rent of land as such is of more practical impor- 



RENT, INTEREST, AND CAPITALIZATION 223 

tance than the rent of any other class of capital goods, as 
land is more frequently held under lease than any other 
class of capital goods. For this reason, and because land 
rent displays certain peculiar characteristics, it is worth 
while to devote especial attention to a study of the laws 
determining it. 

Let us assume that the construction of a railway throws 
open to exploitation a large section of territory in the Brit- 
ish Northwest, and that all the land is at once bought up 
by wealthy persons who intend to hold it permanently, 
parceling it out in tracts suitable for tenant farmers. We 
shall further assume that the owners of the land leave its 
equipment with auxiliary capital goods entirely to the ten- 
ants, and that the deterioration of the land is so slight as 
to be negligible. Whatever the tenant can be made to 
pay, under these conditions, is practically the rent of the 
bare land. 

In making up his bid the tenant will have to estimate, 
on the one hand, the gross receipts from the land which he 
expects to occupy, and on the other hand, all expenses of 
cultivation, including the wages of all labor employed, his 
own as well as that of hired hands; interest on the auxiliary 
capital which he furnishes, whether his own or borrowed 
capital ; and a sum sufficient to replace or repair capital 
goods destroyed or impaired through use. Let us suppose 
that all these items of expense amount to $1000. If the 
tenant has reason to believe that one year with another the 
gross receipts from the farm will be only $1000 he will pay 
nothing at all to the owner of the land for its use. If on 
the other hand he believes that the gross receipts will be 
$2000 he will be prepared to pay a rent of $1000. 

It is obvious that what the tenant can afford to pay for 
the use of the land depends, in large measure, upon the 
rates at which he must reckon the wages of labor and inter- 
est on auxiliary capital. If these rates are high, the deduc- 



224 INTRODUCTION TO ECONOMICS 

tions from gross receipts to be made in calculating rent will 
be large. Accordingly, in order to arrive at the forces de- 
termining the rent of land in the section which we are study- 
ing, we must examine the influences affecting the local rates 
of wages and interest. 

Land in the Canadian Northwest, as in every other part 
of the world, varies in natural fertility and in accessibility. 
If the supply of auxiliary capital and of labor is very small, 
only the most fertile and most accessible lands will be 
cultivated. The owners of slightly poorer or slightly less 
accessible lands will of course derive no revenue from them ; 
they could afford to let such lands for a nominal rent. On 
these lands, then, labor and auxiliary capital are free to 
divide between them whatever they can produce. The labor 
and auxiliary capital employed on the better land can 
demand at least as much for themselves ; if this is refused, 
they will migrate to the unoccupied fields. 

Now let us suppose that a new body of laborers, bring- 
ing with them the appropriate auxiliary capital, enter the 
region. These occupy the lands which in fertility and acces- 
sibility are least inferior to those first cultivated. If after 
this accession of labor and capital any one is dissatisfied 
with wages on the better lands, he may, as before, migrate 
to land still remaining unoccupied. But the unoccupied 
land is now more remote and less fertile than was that exist- 
ing before the accession of the new labor and capital, and 
the product of labor and capital on such lands will be less. 
The cultivator of the better grade of land will therefore 
not have to pay so much for either factor as before. A 
larger share of his gross receipts may therefore be paid out 
in rent. And with every increase in the labor and auxiliary 
capital of the community, remoter and less fertile lands are 
brought under cultivation, with consequent decline in wages 
and in interest on auxiliary capital, and increase in the rent 
of all the better grades of land. At any particular time we 



225 

may say that in this community the wages of labor and the 
interest on auxiliary capital are determined, respectively, by 
the productivity of labor and of auxiliary capital on the 
poorest land actually cultivated. This is of course only 
a special instance of the law stated in earlier chapters, 
that wages and interest are determined by marginal prod- 
uctivity. 

From the fact that when labor and capital flow into a 
new region the rent of land steadily rises, it is often assumed 
that the aggregate of land rents is constantly increasing. 
But it is to be borne in mind that when labor and capital are 
drawn into a new region, the older communities may come 
to be less fully supplied than before. And this would in- 
crease the shares of labor and of auxiliary capital in those 
communities, and reduce the share that is assigned to land. 
The increase in rents in America, in the last half century, has 
in some measure been offset by a decline in rents in Europe. 
If, however, population and capital in reproducible forms 
continue to increase, without any corresponding increase in 
the amount of land accessible to the cultivator, and without 
improvements that increase the general productivity of labor 
and capital, the aggregate of land rent must increase. 

10. A rise in the prices of agricultural products usually 
raises the rent of land. 

In the foregoing example we have assumed that the 
value of the product of a farm remains fixed, while the 
rates of wages and interest vary. Let us now see what 
would be the effect on rent of an increase in the value of the 
product — -which we shall assume to be wheat. Such an 
increase might be brought about by a reduction in the cost 
of transportation. For the local price of wheat is practi- 
cally equal to the price in England, the great wheat market 
of the world, less the cost of transporting the wheat thither. 
If the cost of transportation is reduced five cents a bushel, 
the local price of wheat will rise five cents a bushel. 



226 INTRODUCTION TO ECONOMICS 

If the growers of wheat are forced to rely upon the 
local supplies of labor and capital, the effect of the rise in 
the price of wheat will be an increase in wages of labor 
and interest on auxiliary capital ; the rent of land will 
scarcely be affected. For under the conditions assumed, 
wages and interest are determined by the value of the 
product of these agents on the poorest lands in the com- 
munity actually in use. The value of this product will 
be increased by the rise in the price of wheat ; hence 
wages and interest will rise throughout the territory. The 
cultivator will have greater gross receipts, but he will have 
greater deductions to make under the heads of wages and 
interest. There is no reason why the surplus, or land rent, 
should rise. 

If, on the other hand, close relations have been estab- 
lished between this region and the rest of the world, so 
that wages and interest are determined by the general in- 
fluences prevailing in society, practically the whole of the 
advance in wheat prices will be applied to rent. For sup- 
pose that at first wages and interest are raised above the 
general level. Additional labor and capital will flow into 
the region ; competition will arise for employment on the 
better lands, or worse lands will be put under cultivation. 
Thus the marginal productivity of labor and of auxiliary 
capital will be reduced and the rent of land will increase, 
until labor and capital are rewarded no better than they 
were before — that is, until land rent has absorbed the 
entire benefit of the increase in price. It is true that the 
withdrawal of labor and capital from the general field that 
this movement implies will tend to raise the rewards of 
these agents slightly. But this influence will be hardly 
perceptible. 

We can now understand what it is that forces up agri- 
cultural rents in the vicinity of a growing city. The value 
of the gross product of a given area is constantly increas- 



RENT, INTEREST, AND CAPITALIZATION 227 

ing, as a result of increased demand, while the charges to 
be deducted, wages and interest on capital in reproducible 
forms, are controlled by general laws which are affected 
only slightly, if at all, by the growth of this particular city. 
We can explain in the same way the rise of rent of city 
lots. The aggregate profits from the business that may 
be transacted on a given ground space increase with the 
growth of a city, and as wages and interest on reproducible 
capital do not increase in equal degree, a larger surplus is 
left for the owner of the land. In the same way the rent 
of a railway or a canal in a rapidly developing region 
steadily increases. The railway or canal is a capital good 
which cannot readily be reproduced. Accordingly, if the 
aggregate business to be carried on increases, an increas- 
ing share of the value product of the business will take the 
form of rent on the irreproducible elements. 

11. Growth of population and increase in accumulations 
tend to raise ground rents generally. 

In all the cases that we have examined, an important 
factor in raising rents of land and similar capital goods is 
the influx, or possibility of influx, of capital and labor from 
the general field. If we view society as a whole, there is, 
of course, no possibility of a similar influx of labor and 
capital from outside regions. Nothing can transfer to the 
owners of land the benefits of increased value product ex- 
cept increase in the aggregate supply of labor and auxil- 
iary capital. If these agents remain stationary in quantity, 
while the progress of improvements raises the productivity 
of the units that are placed at the greatest disadvantage — 
that is, if general wages and interest rise — it is obvious 
that the rent of land may fall. So also if population and 
auxiliary capital decrease in amount. If, on the other 
hand, labor and auxiliary capital increase so rapidly that 
wages and the interest on such capital fall, land rents must 
in general rise. It is, of course, possible that increase of 



228 INTRODUCTION TO ECONOMICS 

capital and of labor may be attended by such great im- 
provements in methods of production that wages, interest 
on reproducible capital goods, and land rent will all in- 
crease. This has been more or less true of the economic 
development of the last century. 

12. The process of computing the amount of capital in a 
good from its net rent is termed capitalisation. 

Given the net rent of a capital good and the current rate 
of interest on capital, it is an easy matter to ascertain the 
amount of capital invested in the good. Multiply the sum 
representing the usual net rent by the quotient arrived at 
by dividing ioo by the number representing the rate of 
interest. If the net rent of a farm is $2500 and the 
current rate of interest is five per cent, the capital value of 
the farm is 1 f^X25oo, or $50,000. This process of com- 
puting the capital through the net rent is known as capitali- 
zation. If a building earns $10,000 a year, and there is 
good reason for believing that it will continue to earn the 
same net rent indefinitely, the simplest way of ascertaining 
how much capital is invested in the building is to find how 
large a sum of capital, in general investments, is required 
to earn an equal sum. If the general rate of interest is ten 
per cent, this sum will be $100,000. If the rate of interest 
is five per cent, the sum will be $200,000. In the one case 
the rent is capitalized at ten per cent, in the other case at 
five per cent. 

13. The amount of capital in a reproducible capital good 
is determined by its cost of duplication. The amount of 
capital in capital goods that cannot be replaced is determined 
by the capitalization of their rent. 

In the case of reproducible capital goods, the net rent 
alone is no sufficient indication of capital value. The cost 
of producing similar goods must be taken into account; 
indeed, this is by far the more important element in the 
computation. A ship, for example, may yield a net rent 



RENT, INTEREST, AND CAPITALIZATION 229 

of $10,000 at a time when the current rate of interest is five 
per cent. It would, however, be a reckless business man 
who would assume, from these data, that the ship represents 
a capital of $200,000, and that he could afford to pay that 
sum for it. If a similar ship can be built for $100,000, this 
sum is the true measure of the capital invested. The net 
rent of $10,000 merely indicates that capital in ships is, for 
the time, highly productive. Soon the supply of ships will, 
doubtless, be increased and the net rent will fall to about 
#5000. It may be a year before the decline will take place ; 
in such case the buyer of a ship already afloat can afford to 
pay about $105,000 for it. This sum may be analyzed into 
two parts; $100,000 for the capital in the ship, and $5000 
for the transfer of the extra productivity of the ship through 
one year. If several years must elapse before the net rent 
of ships falls, the second element in the price of the ship 
will be placed at a higher figure ; and if in some way this 
extra productivity could be made perpetual — if the ship, 
worth originally $100,000, could be made to yield indefi- 
nitely $5000 in addition to the normal earnings of the capi- 
tal invested in it — the buyer could afford to pay as much 
for this extra product as for the original capital. That is, 
he would arrive at the value of the ship, not through a com- 
putation of its cost of production, but through a capitaliza- 
tion of its entire net rent. 

Now, a tract of land is a capital good in a situation 
analogous to that of the ship in our hypothetical case. The 
capital invested in the land, in the first instance, may have 
been nothing at all. But if the land yields a net rent of 
$5000 a year, that fact is the only one that buyer or seller 
will need to consider. For it is not possible that the supply 
of similar pieces of land at the command of society will be 
so increased that the net rent will shrink to zero, as would 
be the case with a reproducible good originally costing 
nothing. Because of the natural limitation upon the supply 



230 INTRODUCTION TO ECONOMICS 

of land, there is good reason for supposing that the existing 
rent will continue to be paid indefinitely. The right to re- 
ceive the $5000 land rent for all time is therefore worth 
just as much as the possession of a capital in reproducible 
forms yielding $5000 interest annually. If capital in re- 
producible goods yields, as a rule, ten per cent, the rent of 
the land will be capitalized at $50,000 ; if the current rate 
on such capital is only five per cent, the rent will be capi- 
talized at $100,000. 

Shall we say that a tract of land that yields $5000 rent, 
and is capitalized at $100,000, is really a capital of $100,000, 
or shall we say that the real capital in the land is only the 
sum originally employed to clear it and render it fit for 
economic use ? If we adopt the former mode of expression, 
we shall regard the capital in the land as no more productive 
than capital in any other form. If we adopt the latter mode 
of expression, we shall regard the capital in the land as 
extraordinarily productive. Business men, and many mod- 
ern economists, adopt the former mode of expression. A 
property that yields regularly the income of a capital of 
$100,000 is a capital of $100,000. 

It matters little what mode of expression we employ so 
long as we bear in mind the fact that the value of the land 
is merely the capitalization of its rent at the current rate of 
interest; that with an increase in the rent of a given tract 
of land, if interest on capital in reproducible goods remains 
unchanged, the capital value of the land automatically 
increases, until the ratio of the capital value of land to its 
net rent is the same as the ratio of the capital value of a 
group of typical reproducible capital goods to their net rent; 
that with a decline in the interest rate on capital in repro- 
ducible goods, the value of land yielding a given rent 
increases until the rate of interest on so-called capital in 
land is no higher than the rate of interest on other forms of 
capital. If the rate of interest on capital in reproducible 



RENT, INTEREST, AND CAPITALIZATION 23 1 

capital goods falls, it is because the earning power of such 
goods declines. If the rate of interest on capital in land 
declines, it is usually because the land is revalued at a 
higher figure — that is, counts for a larger sum of 
capital. 

14. Increase in the capital of society causes the value of 
land to rise for two reasons, (1) because it raises the rent of 
land, and (2) because it changes the rate at which a given 
rental is capitalized. 

We have already seen that with increase in the social 
fund of reproducible capital the productivity of such capi- 
tal declines ; the rate of interest falls, and a larger share 
of the product of society takes the form of ground rent. 
This of itself would have the effect of increasing the capi- 
tal value of land. The decline of the interest rate affects 
the value of land further through changing the rate at 
which a given rent is capitalized. If the current rate of 
interest is ten per cent, a certain field may produce a net 
rent of $1000. This sum, capitalized at ten per cent, 
gives a value of $10,000, which we may, if we choose, 
call the capital invested in the field. At the end of two 
decades the current rate of interest may have fallen to five 
per cent. This would naturally increase the rent of the 
field in question — perhaps to $2000. This rent we must 
now capitalize, not at ten per cent, as formerly, but at the 
new current rate of five per cent. The value of the land 
thus comes to be $40,000. 

15. Summary. 

Rent, in the most general sense of the term, is the 
product of any concrete capital good. For practical 
reasons, however, a study of rent may best be limited 
to goods of a fairly permanent character. The gross 
return to a capital good may be divided into two parts, 
one of which serves to replace the good when it is worn 
out, while the other is a net income to the owner of the 



232 



INTRODUCTION TO ECONOMICS 



good. This net income, or net rent, may be regarded as 
the sum of interest on the capital embodied in the good. 

In practice, the rent of a durable capital good may con- 
veniently be treated as a residue remaining after the cost 
of labor and of perishable goods has been deducted from 
the aggregate product. Where several durable goods en- 
ter into a permanent combination, the rent of any one 
may be determined by comparison with other combinations 
into which this particular good does not enter. 

The rent of reproducible capital goods tends, in the 
long run, to equal interest, at the current rate, on the cost 
of duplicating such goods. The rent of goods that can- 
not be duplicated, such as land, can be arrived at only 
through a study of the forces determining wages, interest 
on reproducible capital, and other outlays in production. 
As wages and interest fall, or as value of product rises, 
the rent of such goods increases. The value of irrepro- 
ducible capital goods is arrived at through a capitalization 
of their rent at the current rate of interest. In a develop- 
ing country land values rise on account of increase in 
rent and on account of decline in the interest rate serv- 
ing as a basis of capitalization. 



CHAPTER XIV 
ENTERPRISE AND BUSINESS PROFITS 

1. Exceptionally favorable opportunities for the employ- 
ment of labor and capital are to be found in every progress- 
ive society. 

In many parts of the United States a careful observer of 
business conditions will note neglected opportunities for 
the production of wealth. In one section of the country 
there is a great demand for thoroughbred stock ; very high 
prices are paid for such stock, yet men are slow to equip 
themselves for meeting the demand. Another section of 
the country is known to present excellent opportunity for 
the production of high grade fruit, yet it has few orchards, 
and these of indifferent quality. Fertile lands are to be 
found that yield scarcely anything for lack of water, yet 
plenty of water for irrigation is at hand in a near-by stream. 
Waterfalls offering abundance of cheap power remain for 
years unutilized. 

Nor are exceptional opportunities for wealth production 
limited to the exploitation of neglected natural sources of 
wealth. The richest opportunities are often those of or- 
ganizing in a more effective way businesses already exist- 
ing. In a dairying country, when each producer works in 
ignorance of what other producers are doing, he must learn 
through experience many facts concerning methods of 
production and marketing that could be learned much more 
cheaply through the experience of others. Moreover, the 
product of such a country lacks uniformity and its supply 
is very irregular, with the result that prices are unnecessa- 
rily low and fluctuate seriously. An organization of the 
producers may decidedly increase their income. 

2 33 



234 



INTRODUCTION TO ECONOMICS 



In earlier chapters we have seen what advantages flow 
from the concentration and combination of production. 
At a particular time there is one form of organization best 
adapted to the circumstances, and to introduce this form 
of organization offers an opportunity for rich reward to the 
man or men who are enterprising enough to undertake the 
task. 

In less conspicuous form, exceptional opportunities are 
continually presenting themselves. In a certain city there 
is a corner lot, now occupied by a tumble-down dwelling 
house, that would furnish an excellent location for a gro- 
cery or hardware business. A block of ground in the resi- 
dence part of the city, now occupied by a few old cottages, 
could, in view of present conditions, be profitably cleared 
and sold in large lots to persons intending to build expen- 
sive homes. It may be said, in general, that whenever a 
new business is undertaken, it is with the purpose of ex- 
ploiting a preexisting opportunity for exceptional returns. 
The same thing is true when an established business 
enters new fields of activity. 

2. The function of combining labor and capital for the 
purpose of exploiting a business opportunity is known in 
economics as enterprise. 

In a growing town the time has become ripe for the 
establishment of a wholesale grocery business. Months 
and years may pass before any one undertakes to supply 
the need for such a business, but eventually a man of suffi- 
cient business prestige to command confidence proceeds to 
get together the requisite funds for launching the business. 
He may be wealthy enough to supply the necessary capi- 
tal himself; he may supply a part of it and borrow the 
rest; or he may associate with him in the enterprise other 
persons having capital. The organizing of the business 
involves labor on his part, and some of it of a very high 
order. The essential part of his activity is not, however, 



ENTERPRISE AND BUSINESS PROFITS 235 

the labor involved. What differentiates him from a laborer 
working in a routine way is the fact that he sees a new 
opportunity clearly and takes the steps necessary to utilize 
it. And the reward which he anticipates consists, not in 
wages for his labor, but in the exceptional returns to all 
labor and capital employed, from which he expects a share 
for himself. 

The man who performs the function of combining labor 
and capital for the exploitation of an opportunity is known 
in economics as the enterpriser, or entrepreneur. 

To illustrate the functions of the enterpriser, we will 
suppose that a man of known integrity and business capac- 
ity decides to establish a manufacturing business. He 
borrows at a stipulated rate of interest all the capital that 
the enterprise requires. The actual work of the business 
man himself, we will say, is a negligible minimum. His 
secretaries collect the information on which he acts in de- 
ciding to found such a business. His attorneys arrange 
the details of the loan contract; his banker finds for him 
the persons who have capital to lend. Even the business 
of selecting a building and choosing a responsible manager 
is given over to salaried employees. What, then, is the 
connection of the business man with the enterprise? He 
lends it his name, he assumes legal responsibility for the 
conduct of the business, and he reserves to himself the ul- 
timate power of approving or vetoing proposals made by 
his staff. These are the only functions that the enter- 
priser must necessarily retain. 

In real life it would be difficult to find a man who is an 
enterpriser and nothing more. It is rarely the case that 
a man without capital can borrow any considerable amount 
of it. Lenders demand the security that only the owner 
of independent resources can give. It would, moreover, 
be a fortunate enterpriser who could find secretaries and 
managers who can be trusted to the extent we have as- 



236 INTRODUCTION TO ECONOMICS 

sumed. A part of the labor of oversight must ordinarily 
be performed by the business man himself. The fact that 
the same man ordinarily combines in himself the functions 
of enterpriser, laborer, and capitalist does not, however, 
make the functions indistinguishable. 

3. Opportunities for enterprise are most common where 
economic conditions are rapidly changing. 

When the population of a city increases rapidly, oppor- 
tunities for new business enterprises emerge one after 
another. Profits are to be made by converting residential 
districts to business uses, and by opening up new residen- 
tial districts upon lands adjacent to the city. Increase in 
the number of large incomes in a city offers opportunity 
for businesses catering to the tastes of the rich. The in- 
creasing numbers of persons without means renders pos- 
sible the establishment of new manufacturing enterprises. 
A multitude of business opportunities arise when a new 
railway line is opened; when improvements are made in 
the means of producing or transmitting power; when the 
tastes of consumers undergo a marked change. Enter- 
prise languishes, on the other hand, where population is 
stationary and habits of consumption are fixed. Inventions 
of a far-reaching character may give a fillip to enterprise 
even in such a community; but after a time readjustments 
are made, and enterprise again becomes dormant. It is in 
new and developing countries like the United States where 
enterprise assumes its highest importance. 

4. Enterprise often entails risks, but this is not necessarily 
the case. 

An enterprising person, struck by the natural beauties of 
a mountain valley, decides to erect a summer hotel. He 
sinks his own capital and whatever capital he can borrow 
in erecting a building and in improving the grounds about 
it. The outcome may greatly exceed his expectations; 
throngs of patrons may seek admission to the hotel, en- 



ENTERPRISE AND BUSINESS PROFITS 237 

abling him to fix his charges at a very high level; and even 
this may increase the popularity of his house, since high 
charges are often accepted as a guaranty of exclusiveness — 
the quality for which men are most willing to pay liberally. 
The event may, however, be far less favorable; a few strag- 
gling seekers for rest and quiet may be the only patrons 
secured, and these may hardly pay the running expenses 
of the business. In such a case the enterpriser loses not only 
his prospects of prosperity; he also loses, for all practical 
purposes, whatever capital he has embarked in the enter- 
prise. 

Many enterprises, however, involve no risk. When a 
railway opens a new country, much of the land along the 
route is certain to rise in value, and those who are enterpris- 
ing enough to buy before the rise are certain of a substan- 
tial return. The success of many enterprises involving or- 
ganization is capable of almost mathematical demonstration. 
The exact measure of profit is usually uncertain, but that 
such an enterprise will afford the requisite minimum of 
return, may be clearly shown. The highest type of enter- 
priser is the one who places nothing at stake until his cal- 
culations prove that there is practically no chance of loss. 

5. The existence of valuable opportunities involving no 
risk implies the fact that competition does not operate freely. 

The question naturally arises, how can opportunities in- 
volving no risk, or little risk, be found ? If competition 
were keen, each opportunity would be seized upon as soon 
as the chances of gain seemed to outweigh the chances of 
loss. But competition seldom operates perfectly. Many 
men are conservative, and show a preference for the well- 
established routine. These men overlook most of the op- 
portunities within their reach. Other men see the oppor- 
tunities, but through lack of capital, business prestige, or 
managing ability, are not in a position to avail themselves 
of the opportunities that are presented. This is especially 



238 INTRODUCTION TO ECONOMICS 

the case where the initial outlay required is a large one. 
You may know of an opportunity for the profitable invest- 
ment of $100,000; but if you have no capital of your own, 
you will find it almost impossible to induce other men even 
to listen to your project. The opportunity will probably 
wait for the man who has both enterprise and $100,000, or 
sufficient business prestige to induce other men to intrust 
him with their capital. 

6. The income which originates in enterprise is known as 
profit. It may be defined as a surplus remaining after costs ; 
including interest on all capital and wages for all labor, 
have been met. 

In earlier chapters it has been shown that the returns 
to the average business enterprise must be sufficient to 
cover all costs of production, including under this head not 
only actual outlays, such as prices paid for materials, wages 
of hired labor, and interest on borrowed capital, but also 
ordinary returns on the capital owned by the business man 
himself and a reasonable wage for his labor. An excep- 
tional opportunity is one that will do more than this. A 
surplus remains in the hands of the enterpriser after all 
costs have been met. This surplus is known in economics 
as "pure profit," or more simply, as "profit." We must be 
careful to distinguish profit in this sense of the term from 
the income known as profit in the language of business. 
In the latter sense profit often includes interest on the 
enterpriser's capital and wages for his labor. Profit in the 
economic sense of the term is not essential to the continued 
operation of an established enterprise. Profit in the busi- 
ness sense of the term is a necessary income, since no one 
would remain long in a business unless he obtained a re- 
turn representing interest on his capital and wages for 
his labor. 

7. The profits from an enterprise are commonly due to the 
fact that labor and capital, in that enterprise, are unusually 



ENTERPRISE AND BUSINESS PROFITS 239 

productive, but are rewarded according to the standards gen- 
erally prevailing. 

In any important industrial center the productivity of 
labor and of capital may at a given time vary from industry 
to industry, while the wages of labor and interest on loan- 
able capital vary little, if at all. We may arrange the 
different industries of such a center in a series, according 
to the degree of productivity of labor and capital in each 
one. Labor and capital will, as a rule, receive no higher 
rewards in any industry than in the one that stands lowest 
in the series. If we assume that in this least productive 
industry labor and capital receive all that they produce — 
and we cannot assume that they receive more than this — 
we see clearly that they must receive less than they pro- 
duce in all the industries higher in the series. In the more 
productive industries the products of labor and capital 
afford a surplus above wages and interest, which takes the 
form of a profit to the enterpriser. 

Let us suppose that the American public, awakening to 
the significance of the ghastly record of railway accidents, 
insists that steel passenger coaches replace the wooden 
cars now in use, and withholds its patronage from railway 
companies that refuse to change their equipment. The 
demand for steel cars would become enormous. The car- 
building companies, for a time, could sell their output at 
very high prices. The productivity of labor and capital 
in such establishments, measured in terms of price, would 
be abnormally high. But the wages of laborers engaged 
in building steel cars would be practically no higher than 
the wages of equally skilled laborers in any other branch 
of the iron and steel industries. There would accordingly 
be a surplus above costs, or a profit to the enterpriser. The 
car-building companies would pay no higher rate of interest 
on borrowed capital than any other manufacturing com- 
panies in the vicinity. A surplus originating in the ab- 



240 INTRODUCTION TO ECONOMICS 

normally high productivity of capital would thus be added 
to the profit from labor. 

In any industry the productivity of labor and capital 
may vary from establishment to establishment, although 
there may be no variation in the rates of wages paid. We 
may, if we like, arrange the establishments in a series, ac- 
cording to the degree of productivity of labor and capital, 
just as we did in the case of industries of varying produc- 
tivity. No higher wages or interest will be paid by any 
establishment than by the establishment working at the 
greatest disadvantage. As this establishment will pay to 
labor and capital no more than these agents produce, it 
follows that the better establishments will not need to 
pay out in wages and interest the whole product of labor 
and capital. A profit is left over for the enterpriser. 

8. Profits, in some instances, are explained by the fact 
that labor and capital, though not more than normally pro- 
ductive, are secured at abnormally low rates. 

Certain classes of laborers are in an exceptionally weak 
position, and may be compelled to accept wages decidedly 
lower than the prevailing rate. Immigrants from countries 
with a different language and a lower standard of life 
must often accept conditions of employment that are 
exceedingly unfavorable. In some cases, indeed, they 
have been held in quasi-bondage and compelled to work 
at wages that are unreasonably low. Where employers 
are of one race and employees of another, a set of institu- 
tions may develop which give the employer whatever re- 
mains of the product of labor above a mere minimum of 
subsistence. In some parts of the United States convicts 
and persons condemned to the workhouse are farmed out 
at rates that enable the employer of such labor to reap 
large profits. Women employed under the sweating sys- 
tem, and, to a less extent, women employed in factories 
and shops, are often paid less than their labor is really 



ENTERPRISE AND BUSINESS PROFITS 241 

worth, according to competitive standards. In the history 
of every industrial country, instances have appeared of 
large profits founded upon the exploitation of child labor. 

A similar exploitation of capital sometimes occurs. Not 
many years ago, in some of our states, persons intrusted 
with public funds habitually employed such funds for 
their own advantage. Such a course of action, even 
when not unlawful, was generally disapproved, and 
hence was kept secret, so far as possible. Loans of 
such funds were made at rates low enough to pur- 
chase silence from the borrower, who, accordingly, was 
placed in a position where he could make large profits. 
Trustees having little interest in their wards have been 
known to lend the funds intrusted to them at abnormally 
low rates. Instances of this kind are by no means so rare 
as they are generally supposed to be ; but recognition of 
this fact must not lead us to the view that profits are 
normally the result of conscienceless exploitation. 

9. Profits may arise from the transportation of labor 
or capital from regions of low productivity to regions of 
high productivity, under contracts in which rewards are 
based upon standards prevailing in the regions of low prod- 
uctivity. 

Let us suppose that an employer of large numbers of 
unskilled laborers in the United States sends agents to 
Europe, or even to the Orient, to obtain a supply of labor. 
What the agent will offer for, say, two years' labor will be 
the local rate of wages for that period of time together 
with such a premium as may be necessary to overcome 
the reluctance of laborers to leave their native land. The 
cost of labor is thus determined chiefly by the standards 
of productivity prevailing in countries from which the 
laborers are imported, while the value of the labor to the 
enterpriser is determined by American conditions of prod- 
uctivity, which are admittedly more favorable. By virtue 



242 



INTRODUCTION TO ECONOMICS 



of the labor contract the employer is thus enabled to re- 
tain for himself a part of the product of the labor. 

It is obvious that the possibility of obtaining a profit of 
this nature depends in large measure upon the character 
of the laws relating to labor contracts. If the enterpriser 
cannot enforce the contract by law the laborers whom he has 
imported may desert him before their services have yielded 
adequate compensation for the cost of bringing them to 
the country. In the United States to-day, not only would 
such a contract be unenforceable, but the importation of 
laborers from foreign countries under such contracts is a 
punishable offense. This was not formerly the case, and 
one of the important sources of profits in early American eco- 
nomic history was of the character that has been described. 
There is reason to believe that the system is still exten- 
sively employed in the United States. The importer of 
contract labor relies upon the ignorance or loyalty of the 
laborer to protect him from loss through the repudia- 
tion of contracts. In many parts of the world, especially 
in the tropics, the contract labor system is widely used. 
There are companies which make it their sole business 
to supply enterprisers with contract laborers from China 
and India. Such companies derive their profit from the 
product of the laborers, part of which is made over to the 
company by the enterpriser who employs the laborers. 

We need not here consider the reasons that have led to 
the general condemnation of enterprise that relies for its 
profits on contract labor. What we are more immediately 
concerned with is the possible extent of profits of this nature. 
Let us suppose that the Chinese coolie in his own home 
can obtain an annual wage of $50, while his services on a 
Spanish-American plantation or other enterprise are worth 
$250 per annum. Allowing $150 for bringing the laborer 
from China and for his return, and $50 a year to overcome 
his reluctance to leave his native land, there would remain, 



ENTERPRISE AND BUSINESS PROFITS 



243 



on a two-year labor contract, a profit of $150 to the enter- 
priser, if he imports the labor directly, or to be divided be- 
tween the enterpriser and the coolie labor company, if the 
latter acts as intermediary. 

We may apply the same reasoning to the case of profits 
arising from the transfer of capital from regions where its 
productivity is low to regions where its productivity is 
relatively high. A mortgage loan company may borrow 
capital in New York at five per cent interest and loan it in 
Texas at seven per cent. The loan company thus receives 
a profit of two per cent. How is this profit produced? 
Clearly it is a part of the product of the capital set at work 
in Texas. 

10. Profits may arise when commodities which sell at prices 
covering costs in high wage-standard regions are worked up 
in regions having a low wage-standard. 

The prices charged by American bookbinders for the 
binding of books are based upon the cost of labor in this 
country, which exceeds the cost of equally efficient labor in 
foreign countries. There are men who ship books from 
the United States to Paris to have them bound, as the cost 
of transportation is not high enough to equal the saving in 
wages. The net saving represents a profit to the enter- 
priser. There are metropolitan publishing houses that 
have printing done in small towns, where rates of wages for 
printer's labor are less than in the large cities. The profits 
of Southern cotton manufacturers were for a long time de- 
pendent upon the fact that, while the prices they received 
for their products were held at a level sufficient to cover 
costs in New England, the wage level in the South was 
lower than that of New England. Great profits were 
gained by Japanese cotton manufacturers by virtue of the 
fact that while the prices of cotton goods in the Orient had 
to be sufficient to cover the high labor costs in America 
and England, efficient labor could be had in Japan at very 
low wages. 



244 INTRODUCTION TO ECONOMICS 

Profits may also arise through transferring an industry 
from a region of dear coal to a region of cheap coal. If a 
commodity is expensive to transport, profits may be made 
by removing the industry producing it to a point near the 
centers of consumption ; if the materials entering into the 
production of a commodity are exceedingly bulky, profits 
may be made by removing the industry to points near the 
source of supply of materials. With changes in the tech- 
nique of transportation and in charges for carrying goods, 
there are changes in the relative advantages of different 
producing centers ; and those enterprisers who can adapt 
themselves quickly to these changes are able to gain 
profits. 

11. Under certain business conditions, enterprisers as a 
class may reap profits, owing to the fact that the rates of 
wages and interest are slow to change. 

In times of business prosperity it often happens that the 
prices of almost all commodities rise ; or, what amounts to 
the same thing, the products of labor and capital, measured 
in terms of price, increase. For a time enterprisers fear 
that the rise in prices is a merely temporary phenomenon, 
to be followed, perhaps, by a fall of prices to a level lower 
than that existing before the rise. So long as enterprisers 
maintain this attitude, they naturally refrain from enlarg- 
ing their businesses. No enterpriser attempts to entice 
away the workmen in the employ of other enterprisers, as he 
would do if he believed that the high level of prices would 
be maintained, nor does he increase his demands upon the 
fund of loanable capital. There is accordingly no reason 
why wages and interest should rise. The effect of the rise 
of prices is thus to increase the price of the products of 
labor and capital without increasing the cost of labor or of 
the use of capital. If before the rise in prices labor and 
capital received the whole value of their products, it is ob- 
vious that they receive less than this after the rise. A part 



ENTERPRISE AND BUSINESS PROFITS 245 

of the product of labor and of capital remains in the hands 
of the enterprisers as a profit. 

12. Profits are, in most instances, a temporary form of 
income. 

The sources of profit that have been described have one 
characteristic in common : they cannot flow for a very long 
period of time. An importer of coolie labor may, for a 
time, make large profits ; but if he does so, other importers 
appear, and either force up the price of this kind of labor 
at its source or depress the value of the services of coolie 
labor in the importing country. Sweat-shop contractors 
may for a time make large profits out of underpaid labor ; 
but in the end the number of contractors increases, and this 
either raises the wages paid to this kind of labor, or, what 
is more commonly the case, reduces the prices that are 
paid to contractors. Profits depending upon local cheap- 
ness of labor eventually disappear on account of increase 
in competition for such labor and rise in its price, except 
in cases where the supply of such labor is practically un- 
limited, as in the Orient. In such cases the industry must 
eventually develop to such an extent as to create a large 
increase in the product, with a consequent reduction in its 
price ; and thus, in the end, a level of prices of finished 
products is established which corresponds with the lower 
cost of labor, and leaves no margin for profits. If profits 
depend upon superiority of methods, these methods, in 
time, are universally adopted, and prices fall accordingly. 
If profits depend upon industrial misadjustments that 
leave some industries undersupplied with labor and capi- 
tal, they are eventually eliminated by migration of labor 
and capital from the fields that are oversupplied to those 
that are undersupplied. The general profits that attend 
business prosperity are wiped out by readjustments in the 
prices of products and in wages and interest. 

A particular enterpriser may, indeed, obtain a continuous 



246 INTRODUCTION TO ECONOMICS 

income from profits. When he finds that one source of 
profit is running dry, he searches out another. This im- 
plies a rapidly developing state of industry, such as one 
finds in new countries like the United States. In this 
country it is not difficult to find instances of men who have 
enriched themselves now from one source of profit, now 
from another. 

13. Profits dependent upon the various forms of monopoly 
may display a high degree of permanence. 

One of the most important sources of profit is the intro- 
duction of new and more fruitful methods of production. 
So long as such a method is confined to one out of a number 
of competing establishments, prices remain at a level which 
covers cost of production in the establishments which do 
not employ the new method. If the new method of pro- 
duction is really an innovation in industry, and if it is of 
such a nature as to admit of definite description — as, for 
example, a mechanical device for saving labor — the per- 
son who invented it may take out a patent, which will as- 
sure to him the exclusive right of using it for a period of 
time — seventeen years, in the United States. During 
this period he may continue to enjoy the profits arising 
from the use of the method. He may, of course, sell the 
right of use to other persons, in which case he makes labor 
and capital more productive in the establishments buying 
the right, reserving for himself, in the shape of payments 
for the use of the patent, a part of the product of these 
agents of production. 

Somewhat analogous to the profits arising from a patent 
are the profits arising from the use of a trade-mark or 
from the " good-will " of a concern. A certain brand of 
soap has, let us say, a reputation for purity, established by 
long years of honest business. Another soap bearing an- 
other name may be just as pure ; but the consumer has no 
adequate means of determining qualities, and therefore 



ENTERPRISE AND BUSINESS PROFITS 247 

prefers the brand which he has always believed to be good. 
It is evident that the manufacturers enjoying such a firm 
hold on the popular favor can charge somewhat higher 
prices for goods of a given grade than can manufacturers 
who have their reputation yet to establish. So a merchant 
who has established a reputation for upright dealing, or 
who has succeeded in attracting to himself the patronage 
of the wealthier classes of a city, can charge somewhat 
more than can his less fortunate competitors. The public 
esteem which an enterpriser enjoys — the good-will of the 
business — is sometimes only an insignificant source of 
profits. Sometimes, however, it is an exceedingly impor- 
tant source. In many cases the good-will of a manufac- 
turing or mercantile establishment is worth more than its 
aggregate tangible assets. 

The profits arising from patented processes and from 
the good-will of an establishment fall under the general 
head of monopoly profits. The surplus returns to an ordi- 
nary monopoly may be described in the same way. Let us 
suppose that all the manufacturers of tin plate agree to re- 
duce output twenty per cent in order to force up prices. 
If the various producers can be held to their agreements, 
and if new producers can be kept from entering the field, 
there is no reason why every enterpriser in the business 
should not enjoy a permanent profit. In the chapter on 
monopoly price we saw how this can be done. What the 
monopolists do, from the point of view of distribution, is 
this : A group of allied enterprisers throw a fence, as it 
were, around a particular field of industry. They limit 
the amount of labor and capital admitted to the field, so 
that the productivity of these agents remains higher than in 
the unmonopolized fields. The wages and interest paid by 
the monopoly are no higher than wages and interest in the 
unmonopolized fields. Consequently, there remains in the 
hands of the monopolistic enterprisers a surplus or profit. 



248 INTRODUCTION TO ECONOMICS 

14. Monopoly profits may be capitalized in the same way 
as other permanent incomes from property. 

We saw in the last chapter how it is possible to arrive 
at the value of a capital good, such as a field, by capitalizing 
the income at the current rate of interest. Permanent 
profits may be reduced to a capital value in the same way. 
If the profit from a monopoly is $100,000 a year, and if 
there is good reason for believing that it will continue to 
be the same from year to year, the monopoly itself is 
worth as much as a sum of capital that will yield $100,000 
interest per annum. If capital generally yields five per 
cent, the monopoly is worth $2,000,000. If the enterprisers 
having such a monopoly were to sell out their interests, 
they would demand that sum over and above full payment 
for all the buildings, machinery, and other tangible assets 
of their business. The same thing is true of the profits 
arising from the good-will of a business. These profits will 
be capitalized, and the buyer of the business will have to 
add the capital value of the profits to the value of the 
tangible capital goods. 

The value of a patent is found in a similar manner. 
The only difference is that the profits from this source 
cease upon the expiry of the patent. What the buyer 
pays for is the right to a certain estimated income for a 
definite number of years. If the annual income is esti- 
mated at $5000 a year, and the patent has ten years to 
run, the simplest way of arriving at the value of the patent 
is to find the present value of each year's income, and add 
these sums together. If the current rate of interest is four 
per cent, the present value of $5000 due in one year is ob- 
viously equal to a sum which, plus interest for a year, will 
amount to $5000. That sum is about $4807. $5000 to 
fall due two years hence is worth a present sum which to- 
gether with compound interest at four per cent will in two 
years amount to $5000 — $4625. By a similar process 



ENTERPRISE AND BUSINESS PROFITS 249 

— known as discounting — the value of each year's income 
may be ascertained, and by addition, the present value of 
the patent is established. 

15. Profits usually play an important part in promoting 
economic progress and in directing the distribution of the 
productive resources of society. 

All profits, whether monopolistic or not, are, from the 
point of view of distribution, a part of the product of labor 
and capital which various circumstances enable the enter- 
priser to retain for himself. It may therefore appear, at 
first thought, that the existence of profits is evidence of in- 
justice in the distribution of wealth. 

Upon reflection, however, we see that this is not true. 
Profit in many cases plays an important part in stimulating 
economic progress ; in many other cases the existence of 
profit serves as a means of distributing the agents of pro- 
duction in such a way as best subserves the interests of 
society. An income that must exist if society is to be pro- 
gressive and if the best disposition is to be made of its pro- 
ductive resources can hardly be regarded as unjustifiable. 

It is the hope of profits that induces the enterpriser to 
devise improved methods of production, or to adopt im- 
provements devised by others. In doing this the enterpriser 
increases the productivity of labor and capital, reserving 
for himself, as long as he can, the benefits of this increased 
productivity. But sooner or later the new method finds 
general application in the industry, and the enterprisers are 
forced to yield up the benefits arising from it to labor and 
capital, in the form of increased wages and interest, or to 
the consumer of commodities in the form of lower prices. 
In the latter case all laborers and capitalists gain by an in- 
crease in the purchasing power of their incomes. 

When profits arise from a general increase in the de- 
mand for a commodity, the ethical title of the enterpriser 
to the income is perhaps not quite so clear. But such an 



250 INTRODUCTION TO ECONOMICS 

increase in demand shows that the amount of labor and 
capital devoted to the industry affected by the increased 
demand should be increased. Under the competitive sys- 
tem this result can be brought about only through the 
action of enterprisers. Now, if enterprisers received no 
profit from enlarging old works and establishing new ones, 
why should they trouble themselves with doing this ? If, 
on the other hand, they may for a time keep for themselves 
as a profit a part of the price of their products, they will 
naturally endeavor to enlarge their works as quickly as 
possible. When at last as much labor and capital is de- 
voted to the industry as is socially expedient, profits cease 
through rise in wages and interest or through fall in prices. 

Of the forms of profit that are classed as monopolistic, 
those arising from patented inventions and from good-will 
need no defense. The former is the reward for one of the 
most important services to society. The inventor can 
never get for his services, at any time, more than they 
are worth to society ; at the expiry of the patent the inven- 
tion becomes the common possession of all. The profits 
arising from good-will, in the literal sense of the term, are 
a reward for honorable business dealing, and can be re- 
tained only so long as the enterpriser is worthy of them. 

16. The profits of an ordinary monopoly cannot be ethic- 
ally justified. 

The profits of an ordinary monopoly, so far as they are 
true monopoly profits, stand on an entirely different footing. 
The productivity of labor and capital in the field controlled 
by the monopoly is rendered abnormally high, not merely 
through superior organization and combination of these 
factors in production, but largely through the maintenance 
of an artificial scarcity of them, which is directly opposed 
to the interests of society. While the action of any one 
out of a number of competing enterprisers, each striving 
to increase his own profit, usually operates to increase the 



ENTERPRISE AND BUSINESS PROFITS 251 

aggregate wealth produced by society, the action of a com- 
bination of enterprisers striving to secure a monopoly 
profit operates to reduce the aggregate wealth production 
of society. Through his anti-social conduct the monopolis- 
tic enterpriser receives a permanent profit, the fruits of other 
men's labor and capital. The enterpriser who carries on 
business under conditions of competition receives, as a re- 
ward for his important services to society, only a temporary 
profit. 

It appears, therefore, that the elimination of monopoly 
profit through legislative action, if possible, is eminently de- 
sirable. It is, however, to be borne in mind that this can- 
not always be done without injustice. We have seen that 
monopoly profit, being permanent, may be capitalized. If 
a combination of manufacturing enterprises makes possible 
a monopoly profit of $100,000, the selling value of the com- 
bined enterprise — or of the capital stock representing it — 
is increased by the capital value of an income of $100,000. 
Now, the original promoters of the monopoly do not con- 
tinue to own it forever. Some of the stock in it may pass 
to their heirs ; some of it may be sold to persons who do not 
know that a great part of its value is merely the capitaliza- 
tion of a wrongful monopoly profit. If, then, the profit of 
the monopoly is eliminated, the latter class of persons find 
themselves deprived of an income the right to which they 
purchased in good faith as an income from capital. 

17. Summary. 

In a progressive society exceptional opportunities for 
the employment of labor and capital are continually pre- 
senting themselves. The act of seizing upon such oppor- 
tunities is known as enterprise ; the income arising from 
enterprise is pure profit. The existence of profitable op- 
portunities is evidence of the fact that competition does 
not operate freely. 

From the point of view of distribution profit is an income 



252 INTRODUCTION TO ECONOMICS 

created by labor and capital, but retained by the enterpriser. 
When labor and capital are abnormally productive, but are 
paid at normal rates, a surplus remains for profit ; when 
labor and capital are normally productive, but are paid at 
abnormally low rates, a similar surplus appears. The im- 
portation of labor and capital from regions of low produc- 
tivity to regions of high productivity, with the maintenance, 
in the latter regions, of the standards of pay established in 
the former regions, is one source of profit ; the transfer of 
an industry from a region in which standards of pay are 
high to a region where such standards are low is another 
source of profit. 

As a rule, profit is a temporary form of income. Mo- 
nopoly, in its various forms, gives to profit a fair degree of 
permanence. Monopoly profit is therefore capitalized like 
any other form of permanent income. 

Since profit is an income produced by the labor and capi- 
tal of one set of men and enjoyed by another set of men, 
it appears to demand an ethical justification. Competitive 
profits may be defended on the ground that they serve as 
an incentive to improvement, and help to adjust the supply 
of each commodity to the demand for it. Such forms of 
monopoly profit as the royalties of an inventor and the 
receipts from the good-will of a business are easily de- 
fended. The profits of an ordinary monopoly cannot be 
defended, ethically ; their continued existence depends 
upon the preservation of a misadjustment of demand and 
supply. 



CHAPTER XV 

MONEY 

1. Money is anything that practically all men are ready 
to accept in exchange for their goods, with the expectation of 
employing it in the acquisition of other goods. 

In the foregoing chapters frequent use has been made 
of the concept price, which of course implies the concept 
money, since price is nothing but exchange value, expressed 
in terms of money. It has been tacitly assumed that money 
is in generalise and that its value remains constant, price 
fluctuations being due to changes in the conditions of pro- 
duction or consumption of other things. The latter assump- 
tion, as every one familiar with recent discussions of economic 
policy is aware, cannot pass unchallenged. The value] of 
money, like the value of all other things, is subject to con- 
tinual fluctuations, and these fluctuations give rise to some 
of the most important problems of practical economics. 

We may profitably begin this part of our study by con- 
sidering what it is that the plain man regards as money. 
Anything that is accepted by practically every one in ex- 
change for his goods or services, with the sole intention of 
exchanging it ultimately for other goods or services, is 
popularly regarded as money. This view,"f which is also 
that of many of the ablest writers on money, we may safely 
adopt as our own. Under different conditions of economic 
development, different concrete things have served as money, 
— shells, beads and other ornaments, bits of metal coined 
or; uncoined, and even such commodities as cattle and furs. 
With the evolution of trade, a corresponding evolution of 
money has taken place, and those forms of money which 
were fitted for use when trade was merely an incidental 

253 



254 INTRODUCTION TO ECONOMICS 

part of economic life have; given way to forms of money 
adapted to a complex system of commerce. 

2. The origin of money is to be sought in a gradual and 
ttnconscious evolution in which certain articles of dii r ect use 
came to be more and more frequently accepted] in exchange 
merely as a means of acquiring other articles of direct use. 

The origin of money antedates all historical records. 
Nevertheless, we know enough about the life of primitive 
man to construct a plausible view of the circumstances 
under which money mustfnave come into existence. In 
the earlier stages of human evolution exchange, at least in 
the modern sense of the term, was unknown ; hence, of 
course, money could not have existed. When it first be- 
came customary to make exchanges, goods were doubtless 
bartered directly for goods, as is sometimes the case even 
to-day. Certain articles, however, were more frequently 
the objects of exchange than others, as, for example, 
strings of seashells, articles of copper, silver, and gold 
suitable for personal adornment. Such articles, unlike) the 
common necessaries of existence, could not be produced 
by any one desiring them. Not being essential to life, 
they would naturally be sacrificed by their possessors in 
time of need. The desire for such articles, on the other 
hand, could not be easily satiated. We can easily see, 
therefore, why articles of this nature should have been 
among the earliest to be freely purchased and sold. We 
can also see why persons having ordinary commodities to 
dispose of should have been willing to acceptjsuch articles 
with at least a half -in tendon of exchanging them later for 
other commodities. Men desiring such articles, and will- 
ing to make sacrifices to obtain them, could easily be 
found. 

Just at what point articles of personal adornment, as, 
for example, silver bracelets, ceased to be ordinary com- 
modities and became money it would of course be impossi- 



MONEY 255 

ble to say. Some men may have accepted them solely 
with a view to a further exchange. Some may have ac- 
cepted them primarily with a view to further exchange, 
yet with the alternative of personal use before them ; still 
others may have accepted them with no intention of ex- 
changing them for something else. To the first class of 
persons, the bracelets would have been money ; to the 
second, neither money nor ordinary commodities but some- 
thing half way between ; to the last class they would have 
been merely ordinary commodities. If the last two classes 
were relatively insignificant, the bracelets would properly 
have been called money. We do not hesitate to call 
nickels and dimes money, although certain of the aborigi- 
nal inhabitants of the United States perforate all they can 
obtain and hang them in strings from their ears. 

3. The functions of money are (1) that of medium of ex- 
change ; (2) that of store of purchasing power ; (3) that of 
measure of value ; and (4) that of standard of deferred 
payments. 

When a farmer exchanges a load of wheat for money, 
and immediately exchanges the money for household sup- 
plies, the money so far as he is concerned serves merely 
as means for exchanging the wheat for household supplies. 
If the farmer does not immediately purchase the supplies, 
but keeps the money in his strong box against future 
needs, we may say that the money serves as a convenient 
means of keeping the purchasing power originally repre- 
sented by the wheat through a period of time, or as a store 
of purchasing power. If the local dealer is at once a 
grain buyer and a dealer in household supplies, no money 
may actually be used in effecting the exchange. The 
value of the grain is estimated in terms of money, as is 
also the value of the household supplies, and the one quan- 
tity of money value is set against the other. In this case 
money is used solely as a measure of value. If the farmer 



256 INTRODUCTION TO ECONOMICS 

delivers his wheat, but " trusts " the dealer with its value, 
the future obligation of the dealer to the farmer is reduced 
to definiteness in terms of money. The farmer is credited, 
not with forty bushels of wheat, but, we will say, with $35. 
In this way money serves as a "standard of deferred 
payments." 

The primary function of money is that of medium of 
exchange, and from it are derived the other three functions. 
Money serves as a store of purchasing power because of 
its universal acceptability in exchange. It serves as a 
measure of value because men are constantly weighing 
the value of other things against that of money. And 
for the same reason it serves as a standard of deferred 
payments. If you promise to deliver to me one thousand 
bushels of wheat a year hence, I have no very definite 
idea as to the sum of value I am to receive. If you prom- 
ise to deliver to me $1000 a year hence, I have a definite 
idea as to the sum. 

4. Anything serving as money should present in a high 
degree the qualities of uniformity, stability of value, and 
adaptability to transactions of varying magnitude. 

In the early modern commercial centers traders were 
always seriously handicapped by the great variety of coins 
used as money. In every business transaction it was 
necessary to examine the money offered in payment almost 
as carefully as the quality of the articles offered for sale. 
In many cases gold and silver coins passed by weight ; 
but even in such cases there was always some question 
as to the real value of the money, as the coins of different 
countries were of different degrees of fineness. It is 
difficult to appreciate the advantages presented by] a. 
monetary system like that of the United States of to-day, 
in which one dollar represents the same value as any other. 

Hardly less important than uniformity is stability of 
value. If money is to serve as a store of purchasing power, 



MONEY 257 

its value must not be subject to rapid fluctuations. If it is 
to serve as a standard of deferred payments, stability of 
value is of extreme importance. Imagine the inconvenience 
of a standard fluctuating in value as widely as do most of 
the commodities of common use. A man borrowing money 
for a six-months period might find himself, at the end of 
the period, compelled to pay back twice as great a sum of 
value as he borrowed ; or he might escape with paying 
half as great a sum. With such a fluctuating standard all 
contracts involving future payments of money would be- 
come highly speculative. 

For an advanced commercial nation, adaptability of 
money forms to transactions of varying magnitude is of 
great importance. In the rural districts of China, where 
trade is chiefly local and the articles of trade of low value, 
coins of one kind, and these of very low value, meet practi- 
cally all needs. In a country like our own, with the greatest 
variety of business transactions to be performed through 
the medium of money, a wide variety of forms of money is 
required. For the smallest transactions it is necessary to 
have coins of a value which is low, relatively to bulk, as 
bronze cents, nickel five-cent pieces. For slightly larger 
transactions, coins of silver, which represent a greater 
value per unit of bulk, are more convenient. For transac- 
tions involving still greater values, gold coins are better 
adapted than silver ; for the largest cash payments, paper 
money, which may be of any denomination, is the most 
convenient of all. How important is this variety in forms of 
money will be understood by any one who happens to be 
engaged in business in a town where at times the supply 
of small coins is not sufficient to meet the needs of petty 
trade, or in a section where silver coins are employed to the 
exclusion of paper in all transactions involving $10 or less. 

5. Uniformity in the medium of exchange depends upon 
effective governmental regulation. 



258 INTRODUCTION TO ECONOMICS 

From very early times it has been recognized that the 
coinage of money is a business of such great public im- 
portance that it cannot be left to unregulated private 
enterprise. The private coinage of gold and silver has 
indeed sometimes been tolerated. In the United States as 
late as i860 privately coined gold was to be found in cir- 
culation. But experience showed then, as it had often 
shown in earlier periods of the world's history, that private 
coinage results in serious evils. Coins that circulated as 
of equal value differed as much as ten per cent in their 
gold content. Those who were least able to judge the 
probable value of such privately issued coins were likely 
to be cheated in trade with those who were better able to 
judge the value of these coins. Because of such evils the 
issue of coins by private individuals has been prohibited 
by law. All coins are issued directly by government, and 
measures are taken by every well-regulated state to insure 
uniformity of value of money thus issued. 

6. The function of government in issuing money may be 

(1) to stamp the weight and fineness of metal in a coin ; or 

(2) in a restricted sense, to determine the value of money 
regardless of the value of the material composing it. 

The government may hold its mints open to private 
owners of precious metal, coining on their account all the 
metal they offer for coinage. Thus any holder of gold 
bullion can take it to the United States mints and have it 
made into coins. In such case it cannot be said that the 
government determines the value of the coins issued. If 
there is a large production of gold, there is likely to be an 
increase in the amount of gold taken to the mints for 
coinage, and, as we shall see later, a tendency toward a 
decline in the value of the coins. The government assures 
the recipient of a gold coin that it contains the requisite 
amount of pure gold ; practically it assures him of nothing 
more. 



MONEY 259 

When a metal is freely coined on individual account, 
there can be no perceptible difference in value between a 
given amount of the metal in the form of coin and an 
equal amount in the form of bullion. In the United States 
an ounce of uncoined gold is worth just as much as an 
ounce of gold coined. If for any reason gold in the form 
of coins should become more valuable than gold in the 
form of bullion, more bullion would be taken to the mints, 
until the difference in value disappeared. If uncoined 
gold became more valuable than gold in coins, coins would 
be melted down, until again the difference disappeared. 

A government may accept for coinage on individual ac- 
count either gold or silver, or both metals. When gold 
alone is freely coined on individual account, the monetary 
system of a country is said to be based upon gold monomet- 
allism. When both gold and silver are freely accepted for 
coinage, the monetary system is based upon bimetallism. 
The bimetallic system was generally employed in modern 
times until the nineteenth century. Early in that century 
Great Britain adopted gold monometallism, and in the latter 
part of the century the same system was adopted by all 
other important commercial nations. 

When a monetary system is based upon gold freely 
coined by government on individual account, the needs of 
trade require the presence of money composed of other 
materials, such as silver, nickel, bronze, and sometimes 
paper. The value of such forms of money is said to be 
determined by government, since it bears no fixed relation 
to that of the material from which it is made, as is the 
case with the money made from a metal freely coined. 
As a fact, the government issuing such money usually 
adopts measures designed to maintain a fixed relation be- 
tween the value of such money and that of gold. The gov- 
ernment of the United States regulates its currency in 
such a way that a five-dollar bill, or five silver dollars, or 



260 INTRODUCTION TO ECONOMICS 

five hundred bronze cents are always equal in value to a 
five-dollar gold piece. Gold coin, which serves as a stand- 
ard, may rise or fall in value; all other forms of money 
rise or fall with it. All the non-standard forms of money 
are said to be maintained at a parity with the standard 
form. 

7. The only practical way of maintaining all the forms of 
money at a parity is through provision for the exchange of 
any form for the others at the option of the holder. 

If a government issues a limited amount of paper money 
and makes it legal tender, that is, receivable at its face 
value in payment of all debts, public and private, such 
money may circulate at par, with no further provision for 
regulating its value. If I am offered a piece of paper 
which I am certain will be equivalent to $10 in gold in the 
payment of taxes, or in the payment of my debts to other 
persons, there is no reason why I should not accept it as 
readily as $10 in gold. 

If much of this kind of money is issued, however, every 
one may hesitate to accept it in lieu of gold. Dealers may 
refuse to accept it in exchange for their goods ; accordingly, 
it may depreciate in value in spite of the fact that it is re- 
ceivable at par in payment of public dues and existing 
debts. 

To make certain that non-standard forms of money shall 
not fall below their face value in gold, it is customary for 
governments to make provision for redeeming them in gold 
on demand. In the monetary system of the United States 
are to be found coins of gold, silver, nickel, and bronze, as 
well as paper money. Part of the paper money consists of 
gold and silver certificates ; a small part of it, of treasury 
notes, issued in payment for silver bullion; part of it of 
"greenbacks" — promissory notes of the government, a leg- 
acy of the Civil War. All these forms of money are main- 
tained at an absolute parity by the government. The gold 



MONEY 261 

certificates cannot fall below the value of gold coin, because 
for every dollar of such certificates there is a dollar's worth 
of gold coin or bullion in the United States Treasury, payable 
to the certificate holder on demand. The silver certificates 
are likewise secured in value by treasury holdings of silver. 
It is a part of the settled policy of the United States to 
maintain the silver dollars at a parity with gold ; and 
although no specific provision is made by law for the ex- 
change of silver dollars for gold at the treasury, the privi- 
lege of making such an exchange would doubtless be ac- 
corded the holder of silver dollars if the latter showed any 
tendency to depreciate. A reserve of $150,000,000 in gold 
is held by the treasury for the purpose of redeeming any 
greenbacks that may be presented for redemption. Any 
one who desires may exchange the lesser silver, nickel, and 
copper coins for gold by presenting them in suitable quan- 
tities at the treasury. 

8. If a government fails to maintain all its forms of 
money at a parity, those forms that become depreciated tend 
to drive those that are not depreciated from circulation. 
This principle is known as Gresham's law. 

Let us suppose that the government of the United 
States issues a large volume of paper money, and makes 
no adequate provision for exchanging gold for such paper 
at the option of the holder. The value of such money 
would be very likely to depreciate, in terms of gold. After 
depreciation, every person who has payments to make 
in which the form of money is not specified, naturally 
uses whatever paper money he has in his possession, 
and retains his gold. If he has nothing but gold 
in the first instance, he exchanges it for paper, since 
he can get more than $100 in paper for $100 in gold, 
and then makes his payments in paper money. Thus 
gold ceases to pass freely from hand to hand; if it is 
used at all, it is as a commodity, valued in terms of paper 



262 INTRODUCTION TO ECONOMICS 

money. Thus the paper money issued by the United 
States in the time of the Civil War expelled gold and silver 
from circulation. When gold and silver are both freely 
coined it is usually impracticable for a government to 
maintain the two forms of money at an absolute parity. 
At one time an ounce of gold may be worth sixteen ounces 
of silver ; if then silver and gold are coined at a ratio of 
sixteen to one, — that is, if a dollar in silver contains sixteen 
times as much pure metal as a dollar of gold, — the two forms 
of money may circulate at par. Changes in the relative 
production of the two metals, or changes in the demand 
for them, over which no government has complete control, 
may cause silver to rise or fall relatively to gold. Since 
the value of coined metal, when coinage is free, cannot 
differ perceptibly from the value of uncoined metal, a rise 
in the market value of silver, relatively -to gold, will raise 
the value of silver dollars above that of gold dollars. In 
such case the gold displaces the silver from circulation. 
A fall in the market value of silver would result in a dis- 
placement of gold from the coinage. 

In the monetary history of the United States, silver was 
at one time overvalued, in terms of gold ; at another time 
it was undervalued. As a result there was at one time a 
tendency for gold to displace silver from the coinage ; at 
another time silver tended to displace gold. The impossi- 
bility of keeping freely coined gold and silver at an absolute 
parity was one of the principal causes for the general 
adoption by the chief commercial nations of the mono- 
metallic system. 

9. The value of money is its purchasing power. 

Under present conditions all men accept money in 
exchange for their possessions solely with reference to its 
employment in the purchase of other things. We may, 
therefore, define the value of money as its power to com- 
mand other things in exchange, or briefly, its purchasing 



MONEY 263 

power. Other commodities are valued by some men for 
what they will bring in exchange, by other men for the satis- 
faction to be derived from them directly or indirectly. The 
ultimate cause of the value which men who hold ordinary 
commodities for sale ascribe to such commodities is the value 
ascribed to them by those who will use them in the satis- 
faction of wants. There are practically no men who ascribe 
value to money as a means of direct satisfaction. In this 
respect, accordingly, the value of money is a unique phe- 
nomenon, requiring special explanation. 

10. The value of money is measured by its power to 
command commodities in general. 

The value of money, then, is its purchasing power. 
How is this power to be measured ? Evidently not by 
reference to any particular commodity. A dollar may buy 
one and one quarter bushels of wheat to-day and only one 
and one fifth bushels to-morrow. We should not say that 
the value of money has declined, but that the price of wheat 
has risen. For there are probably many other commodities 
in respect to which the purchasing power of money has 
increased. To form a true estimate of the value of money 
we must consider its power to command commodities in 
general. In order to measure changes in the value of 
money we may form a list of the principal commodities, 
showing how much of each a dollar will command at differ- 
ent dates. By the method of averages we can then ascer- 
tain whether the general purchasing power of money has 
changed. This method has long been employed by econo- 
mists, and it has been shown that through long periods of 
time the value of money fluctuates widely. A dollar will 
not buy so much to-day as it would have bought ten years 
ago. Very likely a dollar will buy more ten years hence 
than it buys to-day. 

11. Changes in the supply of money tend to bring about 
changes in the value of money. 



264 INTRODUCTION TO ECONOMICS 

The factors which determine the value of money, and 
hence the general level of prices, are so numerous and com- 
plex that only a provisional account of them can be given 
in this work. It is quite generally agreed that, other things 
equal, the greater the volume of money there is in the 
world, the lower will be the value of any unit of it. It is, 
of course, true that there are in operation many influences 
affecting prices besides changes in the volume of money. 
Hence we cannot say that if the volume of money, twenty 
years hence, shall be twice as great as it is to-day, prices 
will be higher than they are to-day. Yet this fact does not 
make it the less important for us to gain a clear view of 
the effect of a change in the volume of money. 

Let us suppose that through the discovery of a new gold 
field the world's supply of that metal is perceptibly in- 
creased: $100,000,000 worth of gold, let us say, is taken 
from the new mines every year. Some of the new gold 
may be used in the arts, but the greater part of it will find 
its way to the mints of the nations, and issue thence as 
coin. 

The only use which money subserves is that of purchas- 
ing other commodities. The fortunate owners of the new 
mines will therefore enter the market as purchasers, either 
of consumable commodities or of capital goods or rights 
to capital goods — stocks, bonds, etc. There is no reason 
why the production of goods, whether consumable goods 
or instruments of production, should at once increase upon 
the discovery of gold. We may think of the supply of 
such goods as substantially unchanged. Now, new pur- 
chasers, with $100,000,000 to spend, appear upon the mar- 
ket. It is quite evident that competition for commodities 
will increase, and hence prices will rise. 

Let us assume, for the moment, that the rise in price of 
the commodities purchased by the first owners of the new 
gold has no effect in stimulating the production of such 



MONEY 265 

commodities. The enterprisers engaged in the production 
of these commodities, then, will enjoy abnormally large 
money incomes as a result of the high prices at which they 
sell their products. They will have more money to spend 
on other classes of commodities for their own use. As the 
production of these, we assume, has not yet been affected, 
they also must rise in price. And so the new gold will 
percolate from one economic stratum to another, every- 
where raising prices. 

Our assumption that the production of the commodities 
demanded by the original owners of the new gold remains 
unchanged is purely arbitrary. The rise in prices would prob- 
ably lead enterprisers to enlarge their mills, or to run them 
overtime, and this would require more laborers and more cap- 
ital. The total supply of labor and capital at the command 
of society has not, however, been affected by the increase 
in the volume of money. The only way, then, in which an 
enterpriser can secure additional labor and capital is by 
enticing these agents away from the employment of other 
enterprisers. And this, it is evident, must raise the rates 
of wages and interest in the district where the expansion 
of enterprise occurs. 

After the rise in wages, each laborer has more money 
to spend; he will therefore increase his purchases of the 
commodities suitable for his use. The supply of these, 
however, has not yet increased ; their price is, therefore, 
forced to a higher level. Similarly, the increased money 
income of the capitalists raises the prices of commodities 
taken by the members of that class. Eventually not only 
the price of all finished products, but the price of all raw 
materials and other capital goods, and of all labor, will be 
affected. 

The new gold may be first used to purchase consumable 
goods, or it may be used to purchase stocks or bonds. In 
the latter case, the first effect is an increase in the price of 



266 INTRODUCTION TO ECONOMICS 

these securities. But the sellers of the securities will use 
the money to buy other things. Eventually the effect must 
be felt in the market for commodities and labor. 

12. The issue of paper money by a government affects 
prices in the same way that an increase in standard money 
affects them. 

Instead of assuming that the supply of money is in- 
creased through new gold discoveries, we may assume that 
such increase in the money supply is brought about through 
an issue of paper money by the government. Suppose that 
the United States Government, in order to finance projected 
irrigation works, issues $100,000,000 in paper money. This 
money will find its way into circulation through the pur- 
chase, by the Government, of additional supplies and the 
payment of wages to new employees. The supply of steel, 
cement, and other commodities needed by the Government, 
however, is not increased at once by the issue of new money ; 
hence the price of these supplies must rise when the Gov- 
ernment enters the market as an unanticipated purchaser. 
Similarly, wages are forced up by the new demand for 
labor created in this way. Through attempted expansion 
of business and through increased liberality of expenditure, 
the enterprisers and laborers first affected by the increase 
in the money supply transmit its effects, in the form of in- 
creased prices, to men engaged in other industries. In the 
end general prices and general costs are on a higher level 
than they would otherwise have been. 

13. The employment of substitutes for money in effecting 
exchanges operates as an increase in the supply of money. 

Not all exchanges are effected through the medium of 
money. Barter exists even to-day, although this form of ex- 
change may be ignored, as of very slight importance. 
Many exchanges — indeed, much the greater number, in a 
society like our own — are effected through the medium of 
various substitutes for money. Let us suppose that A, a 



MONEY 267 

person of unquestioned financial standing, buys of B com- 
modities worth $100, and instead of paying cash, gives a 
promissory note, due in six months. B in turn may buy 
$100 worth of goods from C, paying for them not with 
cash, but with A's note, properly indorsed. C may use 
the same note to effect a purchase. At any given time a 
vast number of such notes may be at work effecting ex- 
changes, although each one may be transferred only two 
or three times before its maturity. The effect of the use 
of such notes as a means of exchange is the same as that 
of an increase in the supply of money. A man who can 
use a note in this way is enabled to enter the market for 
the purchase of goods as he could not have done if sellers 
all insisted upon cash payment. The effective demand for 
commodities, therefore, is increased, just as it would be by 
an increase in money. We need not at this point carry 
further the analysis of the effects of the introduction of 
such substitutes for money, as these effects will receive full 
discussion in the next chapter. 

14. Changes in the volume of business affect the value of 
money. 

The value of money, as we have seen, is affected by 
changes in the volume of money and in the use of substitutes 
for money. It is also affected by changes in the volume of 
business to be transacted through the use of money. Where 
most men produce for themselves the principal commodities 
which they need, exchanging only their surplus for 
luxuries, a very little money will meet the requirements of 
trade. Where, on the other hand, men produce almost ex- 
clusively for sale, a large volume of money or of substitutes 
for money is required. If we imagine that men suddenly 
change from the system of production for immediate con- 
sumption to the system of production for the market, with- 
out any change in the volume of money and of its substitutes, 
we can easily see that the price level must be lowered. 



268 INTRODUCTION TO ECONOMICS 

Where one commodity under the earlier system was offered 
for sale to the possessors of money, one hundred may be 
offered under the later system. Some sellers of commodities 
would then find that at the scale of values originally exist- 
ing they would be unable to find purchasers with money to 
pay. They would accordingly reduce prices, and so attract 
to themselves a part of the money supply. This would leave 
other sellers without buyers, and these in turn would lower 
prices. Thus the price level would fall or, what amounts 
to the same thing, the value of money would rise, until all 
sellers could find buyers at the prevailing prices. 

The assumption that the system of production could 
change thus rapidly without a change in the volume of the 
media of exchange involves unrealities, as we know that 
exchange and the medium of exchange must evolve to- 
gether. Yet it points to a real fact : that exchange may 
expand more rapidly than the volume of the media of ex- 
change, necessitating a lower price level. 

15. An increase in the supply of money tends to raise 
prices ; but there is no definite relation between the degree 
in which the money supply is increased and tJie degree in 
which prices rise. 

It must now be evident that changes in the volume of 
money are not alone sufficient to explain changes in the 
value of money, or price changes. The development of 
substitutes for money and changes in the volume and 
character of business transactions must also be taken into 
account. Therefore, although we may say that an increase 
in the volume of money will, other things equal, raise general 
prices, we cannot say in what degree any specific addition 
to the money supply will raise prices. A doubling of the 
money supply of the world might conceivably double prices. 
In all probability, however, prices would be increased by 
less or by more than one hundred per cent. For the read- 
justments consequent upon such an extraordinary expansion 



MONEY • 269 

in the volume of money would probably result in vital 
changes in the volume and character of business, the nature 
of which it would be impossible to predict. The reader is 
cautioned against the view that an increase in the money 
supply, brought about in any way that is known to practical 
experience, can leave the industrial mechanism unchanged 
while changing the scale of prices. 

We may also say that, other things equal, all prices will 
be raised by any important increase in the volume of money. 
But we cannot say that all prices will rise in the same pro- 
portion. Indeed, this is something that a little reflection on 
business conditions shows to be impossible. The supply of 
some commodities is easily increased, while the supply of 
other commodities can be increased only after the lapse of a 
considerable time. If the new money is spent largely on 
commodities of the first class, the attendant rise in price is 
quickly counteracted, in some degree, by increase of produc- 
tion. If it is spent on commodities of the second class, there 
can for a time be no such counteracting influence. 

16. Changes in the volume of money give rise to practical 
economic questions of the greatest importance. 

The fact that not all prices rise in the same degree, and 
the fact that some classes of business relations cannot be 
immediately adjusted to price changes, renders the question 
of increase or decrease in the volume of money of vital 
practical importance. Some social classes are affected 
favorably and other classes are affected adversely by such 
changes. 

When general prices are rising, the wages of labor also 
tend to rise. But it may take some time after prices have 
begun to rise before enterprisers decide to extend their 
business operations. The demand for labor, accordingly, 
does not for a time increase and wages remain unchanged. 
The laborer receives no higher wages per week or month ; 
the commodities he buys with his wages have risen in 



270 INTRODUCTION TO ECONOMICS 

price. It follows that the command of the laborer over 
the necessaries and comforts of life is for the time dimin- 
ished. Eventually, to be sure, enterprisers will endeavor 
to enlarge their businesses, and wages will rise. But if 
the prices of commodities continue to rise, it may well be 
that for a long period of time the rise in money wages will 
not be an adequate offset for the increased expense of liv- 
ing. It is a well-known fact that during the Civil War 
the prices of commodities rose far more than the price of 
labor. 

For many services compensation is fixed by law or by 
custom. The salaries of public officials remain fixed through 
long periods of time, notwithstanding changes in the price 
level. The postal employee receiving $2000 a year is seri- 
ously injured if prices of commodities rise, since years 
may elapse before the Government grants him an increase 
of salary. Physicians' fees, in most cases, are regulated by 
custom and can seldom be increased on account of an ad- 
vance in general prices. 

The business relations most seriously disturbed by price 
changes, however, are those of creditor and debtor. Let 
us suppose that a farmer has borrowed $10,000, agreeing 
to pay off the loan in ten years, together with annual inter- 
est at six per cent. After the contract has been made, 
general prices, we will assume, rise twenty per cent. The 
farmer does not have to pay more than $600 interest each 
year, although the purchasing power of that sum has de- 
clined twenty per cent. At the end of the ten years, he 
will not need to pay more than $10,000, although this sum, 
for the same reason, represents a lower value. The creditor 
has been injured through the change in the price level just 
as much as he would have been if the debt had been arbi- 
trarily scaled down to $8333, prices remaining unchanged. 
The farmer, on the other hand, has gained materially. He 
receives higher prices for what he has to sell, and so is 



MONEY 271 

enabled to pay the annual interest and the principal when 
due with much less sacrifice than would otherwise have 
been necessary. 

Enterprisers as a class are benefited through a rise in 
general prices. What they have to sell commands a higher 
price ; their costs of production increase, but not propor- 
tionately. Mention has already been made of the fact that 
wages may not rise so rapidly as prices. Furthermore, 
most enterprisers have some charges to meet that remain 
unchanged from year to year. If they occupy buildings 
and land not owned by themselves, these are probably 
held under long time leases. Until it is necessary to re- 
new such leases, the rental cannot be adjusted to the change 
in the price level. Most enterprisers are heavily in debt, 
and the rise in the level of prices has the effect of reduc- 
ing the burden of such debts, as in the case of the farmer 
of our illustration. A period of rising prices, to the active 
business man, is, therefore, a period of prosperity, whether 
it is a period of prosperity to the people as a whole or not. 

We have only to reverse our argument to show that in a 
period of falling prices, or rising value of money, the wage 
earners as a class gain, because wages do not fall so rapidly 
as prices ; those receiving salaries fixed by law or custom 
gain yet more, because a readjustment of such incomes to 
the new scale of prices is long delayed; creditors gain 
through increase in the purchasing power of the interest 
and principal due them. The enterprisers as a class find 
profits succeeded by losses, and complain bitterly of busi- 
ness depression. 

17. A monetary standard of fluctuating value results in 
serious hardships ; it is therefore natural that efforts should 
be made to rejider the standard more stable through govern- 
mental action. 

The value of money can neither rise nor fall without in- 
flicting unmerited hardship upon some members of society. 



272 INTRODUCTION TO ECONOMICS 

Any change in the value of money, therefore, is an evil. 
The evils of a rise in the value of money are, however, more 
easily perceived than the evils resulting from a fall in the 
value of money. When money rises in value — or, what 
amounts to the same thing, prices fall — enterprisers incur 
losses, and restrict their operations, reducing their working 
force as far as possible. Many debtors find themselves un- 
able to sustain their burdens, and become bankrupt. The 
hardships of unemployment and bankruptcy quickly attract 
public attention. The hardships arising from a fall in the 
value of money, or rising prices, are more widely diffused 
and less patent to the eye of the observer. Wage earners 
and the recipients of fixed incomes, whether from labor or 
from loaned capital, encounter greater and greater difficulty 
in making ends meet, but this fact receives little attention at 
a time when enterprisers great and small are enjoying pros- 
perity. Accordingly, it is quite natural that when prices are 
falling men should endeavor to mend matters through the 
action of government, while the evil effects of a general rise 
in prices are usually left to mend themselves. 

18. In order to check the fall of prices which occurred in 
tJie period from 1874 to 1897, it was urged by many that 
silver should be restored to free coinage, so as to increase the 
money supply of the world. 

In the period from 1874 to 1897 the prices of com- 
modities steadily declined. In 1897 a dollar would pur- 
chase approximately the same amount of commodities that 
$1.50 would have purchased in 1874. Many classes of 
producers were seriously injured by this decline in prices; 
business depression appeared at times to threaten wide- 
spread ruin. The debtor classes in all modern countries 
were seriously burdened, and in some parts of the United 
States, especially in the newer agricultural states of the 
West, a popular demand arose for an increase in the 
supply of money through the restoration of silver to free 



MONEY 273 

coinage at the ratio of 16 to 1 — the ratio prevailing in the 
United States prior to 1873. 

It is not possible, in this book, to enter into the argu- 
ments that were urged for and against the free coinage of 
silver. We may consider, however, the probable effects 
of such a policy upon the American monetary system. 

19. The adoption of free silver in 1896 would probably 
have expelled gold from circulation in the United States. It 
would have reduced the market value of gold and would have 
raised the market value of silver. 

In 1896 the market value of silver had fallen so low that 
an ounce of silver was worth less than one thirtieth of 
the value of an ounce of gold. Consequently, if silver 
had been admitted to free coinage, it would have been 
very profitable to buy up uncoined silver, both in America 
and in other countries, present it at the mints, and exchange 
the coined silver for gold, so long as any gold coins remained 
in circulation. It would obviously have been only a very 
short time before gold would have disappeared entirely 
from circulation. 

The great demand upon the silver supply that would thus 
have been occasioned would no doubt have increased the 
value of that metal. The gold displaced from the Ameri- 
can coinage would have been thrown upon the markets 
of other countries, and would have reduced the value of 
gold there. Nevertheless, an ounce of gold would proba- 
bly have continued to command more than sixteen ounces 
of silver — perhaps twenty ounces. A dollar (silver) would 
then have been worth less, in gold, than a dollar (gold) 
was worth before the opening of the mints to silver. It 
would have been worth still less relatively to commodities. 
That is, general prices in the United States would have 
been forced to a higher level. 

20. An international agreement for the universal adoption 
of bimetallism might have prevented freely coined silver from 
expelling gold from the currency. 



274 INTRODUCTION TO ECONOMICS 

Many persons who shrank from a policy which would 
probably have substituted a silver standard for the gold 
standard in the United States, nevertheless favored the 
adoption of free coinage of silver if the other commercial 
nations could be induced to follow the same plan. 

If all the countries of the world had agreed to coin sil- 
ver and gold freely at the same ratio, it is quite probable that 
coins of both metals would have continued to circulate side 
by side. The chief reason why gold would leave the cir- 
culation of a single country, if placed at an unfavorable 
ratio with freely coined silver, is that in other countries it 
is given a higher coinage value. More gold would be used 
in the arts, perhaps, but much of it would remain in the 
coinage if all countries gave it the same coinage value, 
relatively to silver. 

21. Rise in prices in the decade 1897- 1906 checked agita- 
tion for the free coinage of silver. 

The adoption by the chief nations of free coinage of 
silver would no doubt have resulted in a higher level of 
prices. Other forces affecting prices had, however, begun 
to operate while the free-silver movement was still gaining 
strength. The production of gold was steadily increas- 
ing; in the decade 1890 to 1900 the amount of gold pro- 
duced exceeded that of any earlier decade in the history of 
the world. The annual production in the years 1901-1908 
was still greater, and the increase in the supply reduced 
the value of gold, or, what amounts to the same thing, raised 
the prices of commodities. When it became evident that 
the rise in prices was likely to continue, agitation for the 
adoption of the policy of free coinage of silver practically 
ceased. 

22. A government may raise or lower the value of money 
by increasing or reducing the amount of paper money in cir- 
culation. 

The evils of falling prices are so readily perceived by 



MONEY 275 

almost every one, that in times of falling prices plans are 
usually put forward for releasing the price level from the 
uncertainties attendant upon the production of gold and 
silver by supplementing metallic money with paper money 
issued by government. Advocates of such plans usually 
propose that whenever general prices are found to be 
falling, the government shall issue additional paper money. 
When prices are rising, paper money received at the public 
treasury, it is proposed, shall be destroyed, until a reduc- 
tion in the money supply checks the rise in prices. 

In practice, paper money, when issued, usually takes 
the form of notes, issued in behalf of the government and 
alleged to be payable at the treasury on demand. But a 
government of a sovereign state cannot be compelled to 
meet its promises unless it chooses to do so. Hence the 
person who receives such a note must take it with the in- 
tention of parting with it in the purchase of goods or in 
the payment of debts, not of presenting it at the treasury 
for specie. These' notes therefore represent a net addition 
to the money supply. 

In order to give such notes currency, the government 
endows them with the legal tender quality. If the volume 
of paper money is narrowly limited, it may circulate at 
par. If occasionally we receive paper money in exchange, 
we know that we can use it for the payment of taxes or 
debts. So certain of this may we be, under the conditions, 
and so confident that others are in a like position, that we 
do not hesitate to accept paper money at par in exchange 
for our goods and services. 

If, however, an enormous amount of paper money is 
issued by the government, so that we are all likely to re- 
ceive more of it in exchange than we can certainly use at 
par, we begin to look upon it with suspicion. We exchange 
it, if we can, for "hard money" — gold or silver; if pos- 
sible, we stipulate that we shall be paid in hard money for 



276 INTRODUCTION TO ECONOMICS 

our commodities or services, offering our goods, if neces- 
sary, at lower prices than we would accept if paid in paper. 
Relatively to gold, paper depreciates. If there is very 
much of it issued, no one pays gold if he can avoid it, but 
uses paper instead. Thus specie disappears from circula- 
tion, and paper becomes the only money in use. Under 
the circumstances it is the worst possible kind of money : 
it fluctuates widely in value, falling with rumors of addi- 
tional issues, rising when it is rumored that the govern- 
ment intends to redeem it. At every change in its value 
some men gain unmerited profits and others suffer un- 
merited losses. 

If, as has been said, a government exercises great mod- 
eration in the issue of paper money, depreciation may not 
occur. The increase in money will tend to raise prices, but 
not in very great degree, and if prices are tending down- 
ward this effect may be beneficial. Why, then, do practi- 
cally all students of monetary science agree that paper 
money is always an unmitigated evil ? Because govern- 
ments almost never exercise moderation in the issue of 
paper money. They resort to paper money in time of 
need, usually while carrying on war. Thus they obtain 
funds without burdening the people with taxation. As 
the expenses of the war increase, more and more paper 
money is issued, until hard money is driven out of circula- 
tion, and the redundant paper currency falls lower and 
lower in value, as evidenced by constantly rising prices. 

Another objection to attempts on the part of govern- 
ment to regulate prices through the use of paper money 
is that while it is practicable, politically, to increase the 
circulation when prices are falling, it is not practicable to 
reduce the circulation when prices are rising. In order to 
retire paper money from the circulation, it is necessary 
to resort to additional taxation which will, directly or in- 
directly, bring the money to be retired into the treasury. To 



MONEY 277 

increase taxation for this purpose would be a very unpopu- 
lar policy, especially since a majority of the population is 
likely to look upon rising prices as a sign of prosperity, 
and therefore an unmixed good. The plan of keeping 
prices at a fixed level by the use of paper money must 
therefore be dismissed as impracticable. 

23. A currency based upon gold or silver freely coined 
displays a tendency toward reasonable stability of value un- 
der modern conditio?is. 

So long as the production of the precious metals was 
dependent upon the activity of men of small capital, work- 
ing on their own account, only the richest fields could be 
worked, and these only for a limited period of time. The 
supply of precious metals depended, therefore, upon the 
chance discovery of new fields, and was consequently very 
irregular. At present the principal supply of the precious 
metals comes from the reduction, by large scale enter- 
prise, of low grade ores, which are found in large masses 
in many parts of the world. If the supply of gold in- 
creases so rapidly that the value of gold money falls, 
or, what amounts to the same thing, general prices rise, 
the production of gold is discouraged through the rise in 
price of labor and the materials and appliances used in 
gold production. If the supply of gold does not keep 
pace with the demand for it, and general prices fall, the 
production of gold is encouraged by the decline in wages 
and in the prices of goods used in the production of gold. 
We see, then, that there are forces at work which restrict 
fluctuations in the value of money. We must not, how- 
ever, exaggerate the potency of these forces. Within 
limits which are not so narrow as would be socially desir- 
able, the value of freely coined money fluctuates from year 
to year and from decade to decade. 

24. Summary. 

Whatever men regularly accept in payment for their 



278 INTRODUCTION TO ECONOMICS 

services or in exchange for their goods, with the sole pur- 
pose of exchanging it for other services or goods, is 
money. The primary function of money is that of a me- 
dium of exchange ; money serves also as a means of stor- 
ing value, as a standard of value, and as a standard of de- 
ferred payments. 

In order that money may be uniform in value, its issue 
must be regulated by government. As a rule, a standard 
form of money is established, and the government merely 
certifies the weight and fineness of metal contained in this 
form of money. Other forms of money are issued in 
limited quantities, and it is the aim of a well-regulated 
government to maintain these forms at a parity with the 
standard form. If there is more than one standard form, 
maintenance of parity between them is difficult, if not im- 
possible. When a government fails to maintain its various 
forms of money at a parity, the less valuable forms tend 
to displace the more valuable forms from the circulation. 

The value of money is measured by its purchasing 
power. The purchasing power of money is continually 
fluctuating, owing to changes in the supply of and the 
demand for money. Changes in the supply of money 
may be due to changes in the output of the metal from 
which standard money is made, or to changes in the 
volume of non-standard forms issued by government. 
Changes in the demand for money may be due to changes 
in the general character of business, or to increase or de- 
crease in the volume of substitutes for money. 

A rise in the value of money is tantamount to a fall 
in prices ; a fall in the value of money, to a rise in prices. 
General changes in the price level inflict serious injury 
upon some classes and give unmerited gains to other 
classes. Hence a popular demand for governmental 
regulation of the price level through expansion or contrac- 
tion of the money supply. The free silver movement of 



MONEY 279 

recent years is explainable upon this principle. The adop- 
tion of free silver by the United States would probably 
have raised the world level of gold prices ; it would have 
placed prices in the United States upon a silver basis. 

Under ideal conditions, general changes in the price level 
might be prevented through the issue or retirement of pa- 
per money. Under existing conditions, since the pressure 
for higher prices is always stronger than the pressure for 
lower ones, a consistent policy of issue of paper money is 
impracticable. The only practicable corrective of rising 
prices is the automatic reduction in the output of gold re- 
sulting from the increased cost of extracting gold from the 
ore, just as the only practicable corrective of falling prices 
is the automatic increase in the gold supply resulting from 
lower cost of gold extraction. 



CHAPTER XVI 
FINANCIAL INSTITUTIONS: THE BANK 

1. An important function of the modern economic organi- 
zation is the placing of the control of capital in the hands 
of those who can use it to the greatest advantage. 

In a complex industrial society it is natural that there 
should be some men possessing capital who are unable or 
unwilling to employ it in business undertakings under their 
own management. Some men, while able to use part of 
their capital in the conduct of businesses under their own 
control, are unable to use all of it advantageously. And 
some men, while able to use all their capital part of the 
time, fail to find use for it during some weeks or months 
of the year. On the other hand, there are those who have 
not enough capital of their own for the proper exploitation 
of the opportunities for its employment which they com- 
mand, and still others, while having capital enough during 
the greater part of the year, require an additional amount 
during certain seasons. 

Accordingly, one of the functions of the modern indus- 
trial organization is the transfer of the control of capital 
from those who have a superfluity of it to those who can 
use it profitably. This function, which in view of the enor- 
mous amount of capital to be thus transferred is one of 
vast importance, may be designated by the term " finance." 
Institutions designed primarily to effect the transfer, or 
"placing," of capital are known as financial institutions. 
It is to be noted that we are here using the word "finance" 
in a sense in some respects more restricted, in some 
respects broader, than is usually conveyed by the term. 
But we are justified in this by the analogies of such words 

280 



FINANCIAL INSTITUTIONS: THE BANK 281 

as " capital," " rent," "labor," etc., which have one mean- 
ing in economics and a slightly different meaning in popu- 
lar language. 

2. The transfer of the control of capital may take the 
form of a loan or of a partnership agreement. 

Let us suppose that a mine operator holds a lease of ad- 
vantageously situated coal lands. To develop these lands 
he needs, we will say, a capital of $100,000. A retired 
merchant in the vicinity has $100,000 from which he de- 
sires to get an income without the labor of managing a busi- 
ness on his own account. The mine operator may borrow 
the $100,000, agreeing to pay a stipulated rate of interest. 
On the other hand, he may be willing to form a partnership 
with the owner of the capital, agreeing to share the profits 
in fixed proportions. In either case the capital is virtually 
placed under the control of the mine operator. From a 
legal point of view the distinction between the two methods 
of transfer of capital is clear. If the transfer is effected 
through a loan, the mine operator becomes the legal owner 
of the goods in which the capital is invested, subject to the 
claims of the lender for interest and principal. The lender 
has no voice in the management o.f the business. If the 
transfer of capital is effected through a partnership agree- 
ment, the capitalist becomes part owner of all the capital 
goods employed in the business, and is entitled to a voice 
in the management of it. From an economic point of 
view, the chief distinction is that in the case of a loan 
transfer of capital, the capitalist receives a fixed income, 
not affected by the vicissitudes of the business, while in the 
case of the partnership transfer, the capitalist receives a 
share of the proceeds of the business, fluctuating with the 
alternation of prosperity and depression. 

3. A productive loan is the transfer of capital, reduced to 
terms of money value, usually under a definite agreement as 
to charges for its use and as to time of repayment. 



282 INTRODUCTION TO ECONOMICS 

In its simplest form a loan is a transfer of a sum of 
money from one person to another, with the stipulation that 
a certain return shall be paid for its use and that at some 
future time, usually specified, an equivalent sum of money 
shall be repaid. The borrower naturally transforms the 
money thus obtained into goods at the earliest possible 
moment. If the goods purchased are designed for sale or 
for use in further production, the loan is virtually the 
transfer of capital. Such a loan is called a productive loan. 
If the money is spent for commodities for consumption, the 
loan is called a consumer's loan. The productive loan is 
by far the more common, and we shall concern ourselves 
chiefly with it. 

4. A loan may be disguised under the form of a sale. 

Very frequently loans are disguised under the form of 
sales " on credit." The seller, instead of demanding spot 
cash for his wares, may agree to wait for a certain period 
of time — say, three months — before demanding payment. 
In this case the seller really lends the buyer a sum equal to 
the price of the goods. A company engaged in the manu- 
facture of agricultural implements sells a self-binder to a 
farmer. The latter has not the ready cash to pay for it, 
but expects to have the necessary sum four months later, 
when he sells his crops. He may borrow the money from 
a neighbor, giving his note, payable in four months, with 
interest. Or, instead of borrowing the money and paying 
cash for the machine, the farmer may buy it " on time," 
agreeing to pay for it at the end of four months. In this 
case we sometimes say that the farmer has purchased the 
machine with his credit. If we analyze the transaction into 
its elements, we shall see that this expression is inaccurate. 
The company has not merely sold the machine; it has also, 
in effect, loaned the farmer the money with which to pay for 
it. Every sale " on time " or " on credit " is a double transac- 
tion, involving a sale, in the proper sense of the word, and 
a loan of the capital represented by the goods sold. 



FINANCIAL INSTITUTIONS: THE BANK 283 

5. Lenders intrust the control of their capital only to those 
who have "credit"; that is, reputation for honesty and 
ability to meet their financial obligations. 

It is, of course, obvious that loans, whether productive 
or consumer's, will be made only to persons who have 
"credit"; that is, to persons who are regarded as sufficiently 
honorable and efficient to be willing and able to repay the 
sums loaned when they fall due. A man's credit may rest 
upon his reputation for personal integrity and business ca- 
pacity; more commonly it rests, in part at least, upon 
the fact that he has property which, under the law, can be 
seized by his creditors in case of default in payment of his 
debts. 

There are some writers on economics who regard credit 
as a mysterious productive instrument, a form of capital, or 
at any rate a substitute for capital. The illustration given 
in section 4 shows that this view has no justification. What 
the farmer cuts his wheat with is a capital good, embodying 
capital furnished either by his neighbor or by the agricul- 
tural implement company. This capital existed before the 
farmer gained possession of it, and would doubtless have 
been employed productively by other persons if the farmer 
had not decided to buy a machine. The fact that he buys the 
machine with borrowed capital shows that he believes that 
he can make this capital yield more than the interest which 
he must pay for its use. His " credit " enables him to pro- 
cure capital to use in an employment which he believes to 
be superior to the average in productivity. If he is right 
in his opinion, he is able to keep for himself a part of the 
product of this capital, as a profit. But the profit is not 
produced by his credit, any more than the wheat is cut 
by it. 

6. A document in which the claim of the lender upon the 
borrower is reduced to written form is known as a credit in- 
strument. If the claim thus reduced to writing can be sold 



284 INTRODUCTION TO ECONOMICS 

and purchased, it is known as a negotiable credit instru- 
ment. 

The contract between the lender and the borrower is 
sometimes merely verbal, and rests for its fulfillment upon 
the honor of the borrower. In a larger number of cases, 
the lender enters the sums due him upon his books, and 
claims thus entered are usually collectible through the 
courts. This is the common form of loans effected under 
the guise of credit sales. The creditor may draw up a 
form instructing the debtor to pay the sum due at a speci- 
fied time. Such an instrument is known as a " draft " or 
"bill of exchange." The borrower may, at the time of 
raising the loan, sign a form which specifies the terms of 
the contract. Such an instrument is known as a "promis- 
sory note." The borrower may specify, along with the 
general terms of the contract, certain property belonging 
to him upon which the creditor will have a special claim in 
case of default in payment. A note thus accompanied by 
the pledge of property is commonly known as a "mortgage." 

The claim of a creditor upon his debtor is regarded in 
law as a form of property, and may ordinarily be purchased 
and sold like any other form of property. Claims repre- 
sented by promissory notes, due bills, and bills of exchange 
are very frequently purchased and sold, or " negotiated." 
They are therefore called "negotiable credit instruments," 
or simply, " negotiable paper." Transfer of such instru- 
ments is commonly effected by indorsement ; that is, the 
original claimant signs an order upon the back of the 
instrument, instructing the debtor to pay the sum due to 
a third party named in the order. 

7. Under modern conditions there is a demand for and a 
supply of loanable capital for short periods of indefinite dura- 
tion, for short terms and for long terms. Corresponding 
with these conditions are call or demand loans, short term 
loans and long term loans. 



FINANCIAL INSTITUTIONS: THE BANK 285 

Capital loans display wide variation in the length of 
time for which the lender surrenders control of his capital. 
Sometimes the lender retains the right of calling for his 
capital at any time he desires. Such a loan is known as a 
"call" or " demand " loan. Sometimes the date when the 
debt falls due is fixed at thirty, sixty, or ninety days. Such 
a loan is known as a short term loan. Sometimes the 
loan runs for five, ten, or fifty years. In this case the loan 
may be called a long term loan. This variation in the life 
period of loans is a reflection of the economic situation of 
the various classes of lenders and borrowers. 

At any given time there are men who have more capital 
than they need immediately ; they cannot tell, however, 
how soon they may need all they have. On the other 
hand, there are men who can use capital profitably for an in- 
definite period of time, who can yet return it to its owner 
whenever it is demanded. Thus a man who deals in stocks 
and bonds may find exceedingly profitable employment for 
capital in the purchase of such securities when prices are 
rising. If he is operating with borrowed capital, he can 
sell the securities at any time when payment is demanded, 
and so restore the capital to its owner. 

Again, there are men who can safely part with the con- 
trol of their capital for a definite period of time — say, from 
one to six months. Corresponding with this class of lenders 
is a class of borrowers who cannot agree to pay off a loan on 
demand, but who are able to make arrangements for payment 
at a definite date some weeks or months after borrowing 
the capital. The merchant will serve as a type of this 
class. He can safely purchase a stock of goods with the 
proceeds of a three months' loan, feeling quite sure that 
within the three months he will be able to sell the goods 
and so gain possession of the means of repayment. 

Finally, there is a class of lenders who have no desire 
for the early repayment of their capital. With satisfactory 



286 INTRODUCTION TO ECONOMICS 

arrangement made as to the rate of interest to be paid, they 
may be willing to transfer control of their capital for a period 
of ten, twenty, or fifty years. There is a corresponding 
class of borrowers, who desire capital for investment in 
land, buildings, and permanent equipment, and who would 
be greatly embarrassed by the necessity of early payment. 

There are, then, three distinguishable sources of supply 
of loanable capital, and three corresponding sources of de- 
mand for it. In practical life, of course, with highly de- 
veloped financial institutions, there is a certain degree of 
interchangeability in the different funds of capital. Let us 
suppose that lenders of the first class place their capital 
in a bank, reserving the right of withdrawing it at any time. 
Experience shows that while some lenders withdraw their 
capital each day, new lenders will each day offer capital 
at the bank. Thus the bank has a permanent fund of 
capital which it may lend to business men for stated periods 
of time. Men who wish to lend their capital for long 
periods of time may place it with a bank, which may use 
it in short term loans, experience showing that when one 
business man repays a loan of this kind another will be 
ready to borrow the capital. 

8. The principal functions of the bank are the collection 
of funds of loanable capital that are available for short 
periods only, and the employment of such funds in call and 
short term loans. 

The bank proper is chiefly engaged in providing business 
men with demand and short term loans. The capital em- 
ployed in this way is in part the bank's own, and is perma- 
nently devoted to the purpose. By far the greater part of 
the capital, however, is supplied by other persons, who loan 
their surplus funds to the bank, receiving for its use 
either interest or some other form of compensation. Provi- 
sion for long term loans is usually made by various other 
financial institutions, such as the savings bank, the insur- 



FINANCIAL INSTITUTIONS: THE BANK 287 

ance company, the investment company, and the exchanges. 
These institutions will receive attention in the next chapter. 
Our present concern is the economic nature of the transac- 
tions in which the bank proper is engaged. 

Let us suppose that a bank is established in a town which 
up to the present has had no similar institution. As the 
bank has doubtless better means for keeping money safe 
than are to be found elsewhere in the town, we may suppose 
that many persons will be glad to deposit with it any money 
which they do not immediately need, reserving the privi- 
lege of withdrawing it whenever they need it. On pay 
days salaried employees will deposit most of their month's 
earnings, expecting to withdraw the money day by day to 
meet their current expenses. Similarly, capitalists will 
deposit their annual or semi-annual interest receipts, to be 
withdrawn in like manner for current expenditures. Mer- 
chants will deposit surplus cash which they will not need 
to reinvest in stock for some days or weeks. Lenders 
whose loans have been repaid will deposit the money until 
they find another satisfactory opportunity for lending. 
Thus a great part of the community will use the bank in 
greater or less degree for the storing of surplus funds. The 
sums so deposited are credited to the depositors on the 
books of the bank. 

The use of checks, or written orders for the transfer of 
funds, greatly increases the usefulness of the bank as a re- 
pository of funds of this kind. The depositor, instead of 
going in person to the bank to withdraw money for a pur- 
chase, may give a check for the sum involved in the trans- 
action. The recipient of the check may present it at the 
bank for payment, carrying away the sum in money. If 
he is in the habit of depositing his own surplus funds in 
the bank, he is more likely to deposit the check, instead of 
cashing it. The sum called for in the check is then trans- 
ferred, on the books of the bank, from the account of the one 



288 INTRODUCTION TO ECONOMICS 

person to the account of the other. Thus payment is effected 
without the handling of money by any one. When the check 
system is well developed funds deposited with the bank may 
change owners scores of times without ever leaving the 
vaults. 

The cash intrusted to the bank may amount to a very 
considerable sum. At one time such deposits may aggre- 
gate $50,000, at another time $75,000. Experience may 
show that the volume of deposits never falls below $40,000. 
This sum of $40,000 may be regarded as a perpetual fund 
intrusted to the bank by the body of depositors, although 
actual ownership of each part of it is continually changing. 

The bank is, of course, under no obligation to keep in its 
vaults the money that has thus been intrusted to it. All 
that the bank is required to do is to hold itself in readiness 
to pay the money on demand. So long as it does this, it 
may use the deposits in any way that it may find profitable 
— observing, of course, such restrictions in the use of its 
funds as the law prescribes. And this fact indicates the 
economic nature of such deposits. They are loans, payable 
on demand, the depositor being the creditor, the bank the 
debtor. 

Up to the present point we have been concerned with 
the bank as a borrower of capital. We have now to con- 
sider its position as a lender of capital. Let us suppose 
that one of the inhabitants of the town is a manufacturer 
of hardware, who sells his products "on time " to jobbers. 
This manufacturer has sold, let us say, $10,000 worth of 
products, receiving in lieu of payment notes for $10,000 at 
three months' time. This means, as we have already seen, 
that the manufacturer has made a disguised loan of capi- 
tal to the jobbers. The manufacturer, however, needs his 
capital in order to continue his business of manufacture. 

He may, if his credit is good, borrow $10,000 from the 
bank, agreeing to repay the loan in three months. When 



FINANCIAL INSTITUTIONS: THE BANK 289 

his debt falls due, the notes of the jobbers will also fall 
due ; accordingly, he will find himself in an excellent posi- 
tion to cancel his debt. Other business men will borrow 
from the bank under similar conditions as large a portion 
of the capital deposited with the bank as can safely be 
loaned. When one set of borrowers repays the sums bor- 
rowed from the bank, another set can easily be found. 
Thus the bank has a permanent volume of loans, as well as 
a permanent volume of deposits, although the borrowers, 
like the depositors, are continually dropping out and being 
replaced by others. 

9. A bank loan may be regarded as the purchase of a 
credit instrument^ such as a promissory note or bill of ex- 
change. 

In the foregoing section it was assumed that men who 
wish to secure capital from a bank borrow it directly ; and 
this, indeed, is often the case. When a business man bor- 
rows for the purpose of recovering the control of capital 
which he has loaned, under the form of a sale to other 
persons, he is more likely to take the notes received from 
the latter to the bank for sale. If the notes bear no inter- 
est, the bank, in purchasing them, will deduct from their 
face value interest for the time that will elapse before the 
notes " mature," or fall due. This process of deducting 
interest in advance is known as " discounting." In the 
language of the banking business, the purchase of a note 
is commonly spoken of as the discounting of a note, and 
notes purchased are called "discounts." Discounts are 
evidently nothing but loans. 

When a person desires to borrow capital from a bank, 
he offers his own note, which the bank usually discounts in 
the manner described above. We may think of the borrower 
as offering his own note to the bank for sale. Thus the 
whole volume of bank loans may be regarded as invest- 
ments in credit instruments. 



290 INTRODUCTION TO ECONOMICS 

10. A bank must invest funds intrusted to it in such a 
way that it can quickly regain possession of such funds if 
necessary. 

While the volume of funds intrusted to a bank may, 
under ordinary circumstances, remain fairly constant, ow- 
ing to the fact that new deposits offset withdrawals, it 
would be unwise for the managers of a bank to invest such 
deposits in ways that would make early payment of de- 
positors impossible. At any time depositors may lose 
confidence in the stability of a bank and demand the sums, 
due them. Let us suppose that such a panic of the de- 
positors or "run on the bank" occurs, and that the bank 
has invested the funds intrusted to it in suburban real 
estate. Such property may not be salable, and all the 
bank can do is close its doors until such time as it can 
dispose of its real estate holdings and pay off its deposi- 
tors. This would, of course, mean the ruin of the bank, 
even though the real estate sold eventually at an advance. 

The bank may invest the funds deposited with it in 
government bonds. These always find a market, but 
their price fluctuates, and the bank might incur some loss 
in disposing of its holdings in order to meet the pressing 
demands of its depositors. Moreover, such bonds yield a 
very low rate of interest. 

The notes that are created in ordinary commercial trans- 
actions are one of the most satisfactory forms of bank 
investments. They are usually drawn for brief terms — 
thirty, sixty, or ninety days — and such notes are usually 
given in payment for goods which are salable in a rea- 
sonable time. Thus there is reason for believing that such 
notes can be met when due. If the depositors of a bank 
press for payment, so that the bank cannot await the 
maturity of the notes it holds, it can usually sell them to 
other banks and thus secure the means of immediate pay- 
ment. 



FINANCIAL INSTITUTIONS: THE BANK 291 

In the United States national banks are limited by law 
to such investments as short term notes, bills of exchange, 
and government bonds. Investments in real estate, ex- 
cept for use in connection with the business operations of 
the bank, are prohibited. State banks are also more or 
less narrowly restricted in their investments. 

11. Under modern conditions the greater part of the vol- 
ume of bank deposits arises out of the process of making 
loans. 

It has been assumed, in the foregoing sections, that the 
principal business of a bank is the lending of deposits 
intrusted to it in the form of spare cash. It is only under 
simple conditions that this is a fair representation of the 
business of a bank. In a modern industrial and commercial 
city the deposits of cash represent a very small part of the 
volume of deposits that figure on the books of a bank. 

Let us suppose that a bank commences business with a 
capital of $100,000, consisting entirely of cash. Part of 
this sum — say $5000 — is spent in acquiring a suitable 
building. The remaining $95,000 is held in the safe of 
the bank, to be loaned to business men who can offer 
adequate security. 

A manufacturer offers at the bank acceptable notes 
amounting to $10,000, and gets them discounted. He 
may, if he chooses, carry away with him the cash repre- 
sented by the discounted value of the notes. This, how- 
ever, he is not likely to do. What he wants the money 
for is to make purchases of materials, to pay salaries and 
wages, and to meet other business expenses. The most 
convenient method of payment is by checks drawn on the 
bank. So instead of carrying the money away from the 
bank he is likely to leave it as a deposit, subject to with- 
drawal on demand. Of course there is no reason why the 
bank should go through the form of counting out the cash 
to the manufacturer if it is to be redeposited in this way. 



292 INTRODUCTION TO ECONOMICS 

What it does is to credit the manufacturer with a " deposit " 
equal to the discounted value of the notes which he has 
transferred to it. 

Let us follow in imagination the history of the manu- 
facturer's deposit. In the course of a month he may draw 
checks aggregating a sum equal to the deposit credited to 
him in payment of wages and other expenses. These 
checks may be deposited with the bank by the manufac- 
turer's employees and the merchants who furnish materials 
and other supplies. The employees and merchants draw 
checks upon the bank to cover their expenses, but these 
checks may be redeposited. It is possible that the notes 
originally discounted will fall due and be paid before the 
bank is compelled to surrender any considerable amount of 
cash on account of the loan which it made in discounting 
the notes. 

Let us suppose that the bank has discounted notes 
amounting to $95,000 — a sum equal to its original cash 
holdings. In discounting these notes the bank has credited 
its customers with deposits amounting, we will say, to 
$94,000. As these deposits are drawn upon, the checks 
drawn are largely deposited with the bank under other 
accounts. Very likely not more than $4000 out of the 
$94,000 in deposits is withdrawn from the bank in the 
form of cash. We see, then, that if the bank were to 
limit its loans to the amount of cash actually on hand, the 
greater part of this cash would remain in the bank idle. 

Accordingly, it is natural that the bank should try to get 
a return from its cash by making additional loans. If it 
lends $200,000 on a basis of $95,000 in cash, crediting the 
borrowers with deposits amounting to $195,000, the chances 
are that a larger amount of cash will be withdrawn by 
depositors than if its loans amounted to $95,000 and the 
deposits to $94,000. Yet the withdrawals of cash may 
amount to only $15,000, leaving the bank still with a large 



FINANCIAL INSTITUTIONS: THE BANK 293 

amount of idle cash. It can safely increase the volume of 
its loans and the resultant deposits. As the volume of 
deposits increases, a point must eventually be reached 
where the cash on hand is just sufficient to meet all prob- 
able demands for cash. At this point the bank must cease 
to make further loans. 

12. Every bank receives in the course of its business checks 
drawn upon other banks. Through the clearing system the 
checks received by a bank are balanced against checks drawn 
upon it and deposited with other banks, so that little cash is 
withdrawn from it in the settlement of claims of other 
banks. 

One reason why a bank can extend its loans far beyond 
the volume of the cash in its possession is that checks 
drawn upon it are likely to be deposited with it, instead of 
being cashed. If checks drawn upon one bank are de- 
posited with another bank, withdrawal of cash would 
appear to be inevitable, since one bank does not, except 
under special circumstances, keep a deposit with another 
bank. 

Let us assume that in a town there are several banks 
which we may designate as A, B, C, etc. Some of the 
citizens of the town will deposit their funds with bank A, 
some with B, some with C. Often a man will use his 
check, drawn on bank A, in making a payment to a man who 
keeps his deposit with bank B or C. The recipient of the 
check might of course take the check to bank A, obtain 
cash for it, and deposit the money with his own bank. It is 
more convenient, however, for him to transfer the check, 
by indorsement, to his own bank. The bank then credits 
him with the sum represented by the check, and assumes 
the trouble of collecting the sum from bank A. And 
so every day, we may suppose, checks drawn on bank A 
are deposited with banks B and C ; checks drawn on 
these banks are deposited with bank A. At the end of 



294 INTRODUCTION TO ECONOMICS 

each business day a clerk in the employ of bank A takes the 
checks drawn on B and C and presents them for payment 
at those banks. Similarly a clerk from bank B presents 
for payment checks deposited with that bank, drawn upon 
A and C. One can easily see that such a method of settle- 
ment involves some waste of energy. While a clerk of 
bank A is presenting for payment at bank B checks drawn 
upon that bank, a clerk of bank B is presenting for pay- 
ment at bank A checks drawn upon the latter bank. 
Money is being carried from A to B at the same time that 
money is carried from B to A. Obviously some method of 
balancing can be devised which will save the unnecessary 
labor and risk of thus carrying money to and fro. Espe- 
cially would this be necessary in a large city, where there 
are scores of banks. 

In every important center the banks form an association 
which provides a building or a hall known as a clearing 
house, where representatives of the several banks meet daily 
for the settlement of the claims of each bank upon the other 
banks. The claims of each bank upon all the others are set 
off against the claims of all the other banks upon it. When 
this has been done, it will be found that some of the banks 
have a balance in their favor, while others have a deficit to 
make good. Each debtor bank then pays a single lump 
sum representing its indebtedness to all the associated 
banks ; each creditor bank receives a lump sum represent- 
ing the balance of its claims upon all the banks. By this 
method the transfer of cash from bank to bank is reduced 
to the lowest terms. 

13. The cash kept on hand by a bank to meet probable 
cash demands is known as the reserve. In many cases the 
laws regulating banking require the banks to maintain re- 
serves amounting to a certain proportion of the deposits and 
other demand liabilities. 

If banks are free to extend their loans at will, the amount 



FINANCIAL INSTITUTIONS: THE BANK 295 

of cash kept on hand to meet the possible demands of the 
depositors will vary according to the banking habits of the 
business community and the temperament of the bankers. 
In highly developed commercial communities, very little 
cash is used in effecting exchanges; reliance is placed 
upon the use of checks. In such a community a bank 
may extend its loans, and the attendant volume of its de- 
posits, almost without definite limit. If it keeps on hand 
$10 in cash for every $100 of deposits, it will probably be 
able to meet all cash demands without difficulty. Banks 
have been known to conduct a successful business with 
only $5 in reserve for every $100 of deposits. 

The smaller the proportion of the reserve to the de- 
posits, however, the greater the chance that a bank will 
be unable to meet demands for cash from its depositors 
and other creditors. Failure to meet such demands may 
cause great embarrassment to the customers of the bank. 
If a man cannot draw upon his bank deposit, very likely 
he will be unable to meet his own obligations ; his creditors, 
in turn, are embarrassed in meeting their obligations, and 
so the evil extends in ever widening circles throughout the 
business community. The depositors of other banks, fear- 
ing that their banks will likewise fail to pay cash on de- 
mand, withdraw their deposits until, at times, it becomes 
impossible for those banks to continue to pay cash. 

It is natural that legislatures should attempt to reduce 
the chances of sugh a calamity by regulating the business 
of the banks. A favorite device is to fix by law a mini- 
mum reserve to be maintained by each bank against its 
deposits. In the United States, banks organized under 
federal laws are required to keep reserves amounting to 
fifteen per cent of the deposits in the lesser cities, and to 
twenty-five per cent of the deposits in the larger cities. 
Banks organized under state laws are required to keep re- 
serves amounting to from ten to twenty-five per cent. 



296 INTRODUCTION TO ECONOMICS 

14. The chances of ultimate loss to the depositor of a well 
conducted bank are very small. 

It may seem that even when a bank keeps a reserve 
amounting to twenty-five per cent of its deposits, the deposi- 
tor is in danger of loss. What if more than twenty-five per 
cent of the deposits should be demanded on any one day ? 
The bank would, of course, be unable to make payment 
immediately. 

If a bank is not grossly mismanaged, it has property 
worth at least one dollar for every dollar figuring in its 
deposits. When it makes a loan of $10,000, thus creating 
a deposit amounting, we will say, to $9700, it receives 
from the borrower notes amounting to $10,000, which 
must be set against the $9700 which it owes its depositors. 
If the notes are good, at their maturity the bank will re- 
ceive more than enough cash to cancel the deposits created 
when the loan was made. Every part of the volume of 
deposits is covered in this way by notes, bills of exchange, 
etc., in the vault of the bank. 

These notes, etc., usually run for short periods, seldom 
extending over six months, and frequently maturing in less 
than thirty days. Even if the bank fails to meet its obliga- 
tions on demand, the worst that the depositor usually has 
to fear is that he will have to wait some weeks or months 
until the bank can collect the sums due it. 

But suppose that the notes in the bank's vaults are worth- 
less; that the bank will be unable to collect the sums due. 
In that case, the bank's own capital must be used to meet 
the claims of the depositors. If the volume of worthless 
notes exceeds the amount of the bank's capital, then the 
depositor may suffer loss. 

It is, however, rarely the case that a bank discounts any 
large number of worthless notes. A bank accepts only 
such notes as there is reason to believe are good. Bank 
officials are in an excellent position to judge of the business 



FINANCIAL INSTITUTIONS: THE BANK 297 

standing of the bank's customers. Checks used by these 
customers in payment of their obligations pass through the 
bank; checks received by them are deposited with the bank. 
Thus it becomes fairly easy for competent bank officials to 
ascertain whether a business man is prospering, or operating 
at a loss. In the latter case, the bank forces the payment 
of notes when due, and refuses to make new loans. Thus 
bank loans are, as a rule, restricted to those members of 
the business community who are able to keep themselves 
in a position to pay their debts. 

In some instances, to be sure, banks are ruined through 
fraud. Bank officials may embezzle the funds or may 
extend loans to personal friends to be employed in risky 
ventures which result in total loss. The laws of most 
states are stringent enough to reduce losses through fraud 
to a minimum. 

15. Bank notes are claims upon the bank that ai-e essen- 
tially of the same nature as deposits. 

In the foregoing discussion it has been assumed that the 
transfer of claims upon the bank is made through checks, 
drawn upon a deposit, and redeposited by the holder. A 
man who receives a check may, however, transfer it, prop- 
erly indorsed, to another man, who in turn may transfer 
the check to a third person. Each holder of the check 
becomes in turn the creditor of the bank. When the check 
is at last deposited with the bank, the claim upon the bank 
is formally transferred on its books. But it is obvious that 
the claim on the bank is just as certainly transferred when- 
ever the check changes hands. 

Such a check could not pass through many hands, be- 
cause only those persons knowing the credit of the drawer 
would be willing to accept it. There are men who draw 
checks on banks where they keep no deposit; if you are 
offered a check drawn by some one you have never heard of, 
how do you know that it will be honored by the bank? 



298 INTRODUCTION TO ECONOMICS 

A person wishing to use checks as a means of payment 
among persons who are not certain of his credit may take 
the checks to the bank and have the cashier certify upon 
their face that they represent a deposit, and will be honored 
by the bank. Such checks — known as certified checks — 
may circulate as freely as money in the community where 
the bank's standing is known. It is clear, however, that a 
certified check is a claim upon the bank of the same nature 
as an ordinary check drawn upon a deposit. 

Instead of certifying checks drawn upon a deposit, the 
bank may give the customer who wishes means of ready 
payment a parcel of its own notes, payable to the bearer on 
demand. The customer is then the creditor of the bank 
for the amounts stated in the bank notes in his possession. 
As soon as he uses the notes for the purchase of supplies, 
etc., he transfers the claim upon the bank to the seller of 
the supplies. Such notes may pass from hand to hand for 
years, each successive holder of a note becoming the cred- 
itor of the bank. 

Obviously it makes little difference to the bank whether 
a business man who discounts a note is credited with a de- 
posit on the books of the bank or takes the bank's notes in 
the same sum. The deposit represents a right to cash 
on demand ; the bank notes represent exactly the same 
thing. The deposit may pass from owner to owner through 
checks drawn upon it and redeposited with the bank ; the 
note passes from owner to owner without the formality of 
a transfer on the books of the bank. Any one of the series 
of owners of the deposit may demand cash at any time ; the 
same is true of any one of the series of holders of a bank 
note. For some classes of transactions, it is true, a deposit 
subject to check is the more convenient means of payment, 
while for other classes of transactions bank notes are the 
more convenient. 

16. The issue of bank notes is usually hedged about by 



FINANCIAL INSTITUTIONS: THE BANK 299 

legal restrictions designed to protect the note holder from 
loss. 

The issue of bank notes is usually carefully regulated 
by government, so as to safeguard the holder of notes 
against loss. Now, we have seen that the positions of the 
note holder and the depositor are analogous. Both are 
creditors of the bank ; both have a right to cash on de- 
mand. Why then should the government take greater pains 
to insure the note holder against loss than to insure the 
depositor ? 

The depositor usually lives in the city in which the 
bank which holds his funds on deposit is established. He 
is therefore in a position to know something of the standing 
of the bank. If he has reason to believe that the bank is 
not well managed, he can at once withdraw his deposit. On 
the other hand, bank notes often find their way to distant 
cities. The holders of such notes can know nothing about 
the credit of the issuing bank. For this reason it is only 
just that their interests should be protected by the govern- 
ment. 

Various methods are employed by the different govern- 
ments to protect the note holder against loss. In some 
countries the volume of notes that a bank may issue is 
limited to a certain proportion of the capital of the bank ; 
in case of failure the note holders have a prior claim upon 
all the resources of the bank ; furthermore, each bank is re- 
quired to contribute to a fund for the immediate payment of 
notes of banks that have failed. In the United States na- 
tional banks alone have the privilege of issuing notes ; other 
banks may indeed issue notes, but are taxed so heavily 
on their notes that issue is unprofitable. A national 
bank which avails itself of the privilege of issue must pur- 
chase, and deposit with the United States Treasury, United 
States bonds the par value and the market value of which is 
equal to the value of the notes issued. In case the bank 



3 oo INTRODUCTION TO ECONOMICS 

fails, these bonds are sold, and the proceeds used to redeem 
the notes. Thus it is quite impossible for the holder of 
bank notes to suffer loss, even if the bank of issue fails. 

17. Bank notes and bank deposits serve as currency, and 
reduce the amount of money needed for effecting exchanges. 

In the United States bank notes are used in effecting 
exchanges in the same way that money is used. Every 
one knows that the note holder is absolutely insured 
against loss ; consequently no one takes the trouble to 
present bank notes at the issuing bank for redemption in 
money. Were the issue of bank notes prohibited, a large 
volume of exchanges now effected through their use would 
have to be effected by means of money. We should need 
a much larger amount of money than we now possess to 
carry on the existing business of the country. 

Bank deposits serve in a similar way as a means of 
effecting exchanges. A deposit, we have seen, is not 
a definite sum of actual money, kept safe in the vaults of a 
bank. It is a right to demand money at the bank. When a 
man pays for goods by means of a check drawn on such 
a deposit, he simply transfers his claim upon the bank. 
Such a claim may be transferred again and again, effecting 
scores of exchanges. 

It has been estimated that in the great commercial cen- 
ters of the United States fully ninety-five per cent of the 
total volume of purchases and sales is effected by means of 
the transfer of claims upon banks. Money plays a rela- 
tively more important part in the lesser towns and the 
rural districts ; yet even here it is probable that bank notes 
and deposits effect a larger volume of exchanges than does 
actual money. 

18. Summary. 

The principal function of finance is the transfer of capi- 
tal to those who can use it most advantageously. The 
transfer of capital usually assumes the form of a loan, 



FINANCIAL INSTITUTIONS: THE BANK 301 

either recognized as such, or disguised under the form of a 
credit sale. We may look upon the lending of capital as 
the purchase of such credit instruments as the promissory- 
notes given by borrowers. 

The function of the bank is primarily the borrowing of 
sums of capital available for short periods of time and the 
investment of such sums in short term credit instruments. 
The sums borrowed by the bank are known as " deposits"; 
the investments of the bank, since they represent for the 
most part the face value of the credit instruments pur- 
chased less interest to maturity, are known as " discounts." 
In practice, when a business man sells a note to a bank, 
he leaves the proceeds of the note as a "deposit" in the 
bank, subject to withdrawal by check. In modern banks 
by far the greater part of the volume of deposits is created 
in this way, and not by the deposit of cash. 

While the bank is compelled to pay out its deposits on 
the demand of the depositor, it is rarely the case that many 
depositors demand cash at any one time. This is partly 
due to the convenience of payment by means of checks. 
A depositor who wishes to make a payment draws a check 
in favor of his creditor ; and this check is likely to be 
deposited in the bank by the payee ; thus the payment is 
effected without any withdrawal of cash from the bank. 
Through the system of clearing each bank is protected 
against serious drains upon its cash holdings through 
checks drawn upon it and deposited in other banks. 

While little cash is ordinarily withdrawn from a bank, 
under ordinary circumstances, it is nevertheless necessary 
for a bank to keep on hand a considerable amount of cash, 
to safeguard itself against unexpected demands. The cash 
thus kept on hand is known as the reserve. The amount 
of the reserve should bear a proportion to the deposits 
which varies according to the character of the community 
in which the business is carried on. In the United States 



302 INTRODUCTION TO ECONOMICS 

a minimum reserve is prescribed by law. The ultimate 
solvency of a bank does not depend upon its reserve, but 
upon the character of the notes in which the bank invests 
its funds. These are, as a rule, sound, and the chances 
of bank failure, except through fraud, are small. 

The notes issued by banks are demand liabilities not 
essentially different from deposits. Since notes wander 
far from the bank of issue and are offered in payment to 
persons who can know nothing of the credit of the issuing 
bank, special regulations are adopted by governments to 
insure their payment. 

Bank notes and bank deposits fulfill the functions of cur- 
rency. The amount of money necessary for carrying on 
exchanges is greatly reduced by the use of a deposit and 
note currency. 



CHAPTER XVII 
OTHER FINANCIAL INSTITUTIONS 

1. The making of permanent and long term investments 
may be regarded as the flow of funds from the capitalist 
class to the enterpriser class. 

The chief function of the bank, as we have seen, is the 
supplying of the demand for short term loans, through the 
accumulation and placing of capital which is available for 
use for short periods of time. The creditors of a bank 
and its debtors are, as a rule, members of the same eco- 
nomic class — men actively engaged in trade and industry. 
Each man is, in turn, borrower and lender. In the pres- 
ent chapter we are concerned with the investment of funds 
in credit instruments that run for long terms, or are per- 
haps even perpetual. It is plain that we are here dealing 
with the relations of two fairly distinct economic classes. 
Men who, for one reason or another, take no active part 
in business, place their funds with active business men. 
The former class corresponds roughly with the capitalistic 
class of economic theory, the latter, with the enterpriser 
class. We may, therefore, regard the placing of capital in 
permanent and long term investments as a flow of funds 
from the capitalist to the enterpriser. 

2. The principal sources of demand for long term invest- 
ment funds are ( I ) the purchase and improvement of real 
estate ; (2) the financing of large corporations ; and (3) the 
extraordinary needs of government. 

Throughout the country there is a constant demand for 
capital for the purchase and improvement of real estate. 
Men with small capitals of their own desire to buy farms 
or building lots ; men who possess land desire to prepare 

303 



3°4 



INTRODUCTION TO ECONOMICS 



it for cultivation or to equip it with the necessary stock or 
buildings. Those with insufficient capital — and they are 
many — enter the capital market as borrowers. They ex- 
pect such capital as they may raise through loans to be 
highly productive, but they cannot be sure that they will 
be able to restore it to the lenders for several years. To 
meet the needs of such borrowers, lenders must surrender 
control of their funds for a considerable period of time — 
five, ten, or fifteen years. 

A second source of demand for capital arises from the 
needs of the modern large scale business enterprise. In 
many forms of business the capital necessary for effective 
operation exceeds the amount that an ordinary enterpriser 
owns, or can raise through personal loans. The number 
of million-dollar enterprises in the United States vastly 
exceeds the number of millionaires. Accordingly, it is 
necessary to transfer to a single active enterpriser the 
capitals accumulated by numerous individuals. 

A third source of demand for capital — and the last with 
which we need concern ourselves — arises from the extraor- 
dinary needs of government. Under ordinary circum- 
stances the expenditures of most governments are met by 
current revenues. Owing to unforeseen circumstances, 
revenues may be less than were anticipated, while expen- 
ditures may prove unusually heavy. As it takes time to 
revise a revenue system, a considerable deficit may appear, 
which involves borrowing under one form or another. 

A much more important cause of public borrowing is the 
enormous expense entailed by modern warfare. No great 
war can be carried to a successful issue without the em- 
ployment of far greater resources than any practicable 
system of taxation will afford. Recourse must therefore 
be had to loans. Government loans thus arising cannot 
quickly be paid off. Often loans are negotiated for ten, 
twenty, or thirty years ; and even at the expiration of the 



OTHER FINANCIAL INSTITUTIONS 305 

period for which they are contracted, they are frequently 
paid out of the proceeds of new loans. The greater part 
of the public debt of the United States dates from the Civil 
War ; a large part of the debt of Great Britain had its 
origin in the Napoleonic wars. 

Again, governments may borrow money for the purpose 
of carrying out a policy of permanent improvements. The 
United States, for example, raises the funds for the con- 
struction of the Isthmian Canal through loans. The 
Prussian, Russian, Indian, and Australian governments 
have borrowed vast sums for the purpose of purchasing 
and constructing railways. Cities are continually borrow- 
ing money for similar purposes. Especially where the 
policy of municipal ownership finds favor, the demand for 
capital for public use is enormous. 

3. The principal sources of supply of capital for long 
term investments are: (1) private fortunes accumulated in 
dusiness, whose possessors desire freedom from the labors 
of active management ; (2) the funds of endowed institu- 
tions; (3) the funds accumulated from private incomes and 
kept as a reserve against contingencies. 

Just as there are always men who are entering business 
life, so there are always men who are retiring from active 
business affairs. Men of the latter class desire to obtain 
an income from their accumulations without the labor that 
personal management entails. Universities, hospitals, and 
other institutions receive money endowments, which must 
be invested in such a way as to yield a steady income. 
Wage-earners and professional men are under the necessity 
of putting by a part of their incomes as a reserve against 
sickness and old age, or as a provision for their dependents 
in case of death. Capitalists who look forward to increasing 
burdens save some part of their interest receipts ; active 
business men save part of their profits. Of these savings 
some part is reinvested in their own business by the men 



306 INTRODUCTION TO ECONOMICS 

who save. A great part of the total fund of savings must, 
however, be placed under the control of other persons, if 
it is to yield a considerable income. 

We have now a view of the work that the financial mechan- 
ism must perform. It must gather together the funds of 
free capital and place them under the control of those who 
can make best use of such funds. We may next proceed 
to a study of the methods by which this work of placing 
capital is performed. 

4. The typical instruments employed in the effecting of 
long term and permanent investments are mortgage notes, 
bonds, and stocks. 

The transfer of capital for long terms implies the creation 
of various instruments which serve as evidence of the claims 
of the capitalist. The simplest type of such instruments 
is the promissory note secured by the pledge of property, 
s.uch as houses and lands. Where the sum to be raised 
by a loan is very great, as in the case of corporation loans, 
the resources of numerous lenders must be drawn upon. 
Instead of executing a great number of separate notes, 
representing the amount borrowed from each person, the 
corporation may execute a note, secured by the pledge of 
property, covering the whole sum, and deposit it with a 
trustee. The trustee then prepares certificates represent- 
ing shares in the loan, and delivers them to lenders as 
evidence of the sums loaned. Such certificates are known 
as " bonds." A government may issue similar certificates 
of indebtedness without executing a note representing 
the entire loan. Such bonds are seldom secured by the 
pledge of property. In any case it is clear that govern- 
ment and corporation bonds are merely forms of promissory 
notes. 

Instead of raising money through an issue of bonds, a 
corporation may sell shares of stock which entitle the 
owner not only to an income, but to a share in the manage- 



OTHER FINANCIAL INSTITUTIONS 307 

ment of the enterprise. In law the position of the stock- 
holder is very different from that of the bondholder. The 
former is a partner in the business undertaking ; the latter 
is a creditor of it. In practical life the ordinary stock- 
holder has little to do with the control of a corporation. 
He purchases stocks for the income they yield, just as he 
would purchase bonds for their income. » The bondholder 
is a preferred claimant ; therefore bonds, as a rule, offer 
a more certain income. The different classes of bonds vary 
widely in security, however, and many are inferior to certain 
classes of stocks in this respect. 

Such instruments — promissory notes, bonds, and stocks 
— are clearly not capital, but merely evidence of owner- 
ship of capital. We may, however, think of the purchase 
and sale of such instruments as the purchase and sale of 
capital, since the ownership of the underlying productive 
goods is transferred with the transfer of such instruments. 
For convenience we may speak of notes, bonds, and stocks 
as " investments." Bonds and stocks are commonly 
called " securities." 

5. Investments vary greatly in respect to security. 

Investments of this character, as has been said, differ 
widely in security. The long term notes of business men 
are usually secured by the pledge of tangible property of 
some kind, but the property pledged may represent a more 
or a less adequate guaranty of repayment. A loan secured 
by the pledge of land in a semi-arid region is not so safe 
as a loan secured by the pledge of land in a locality where 
crop failures are unknown. A series of dry years may 
depopulate a semi-arid district, and practically destroy the 
value of land there. Loans secured by suburban real 
estate are not, as a rule, so safe as loans secured by busi- 
ness property in the heart of a city. The bonds of a govern- 
ment like that of the United States are generally regarded as 
safer investments than those of Japan ; the bonds of the lat- 



308 INTRODUCTION TO ECONOMICS 

ter country are safer than those of Guatemala or Venezuela. 
Corporation bonds similarly vary widely in security. Ex- 
perience has shown that corporations frequently become 
bankrupt, and in such cases the bondholders may lose part or 
all of their invested capital. Stocks, as a rule, are yet more 
uncertain investments. When a new interurban railway is 
constructed, no one knows certainly that the business 
which it will carry on will yield a fair return on the capi- 
tal invested ; if it does not do this, dividends on its stock 
will be low. Even in the case of an established business, 
changed conditions may annihilate profits and cause a 
suspension of dividend payments. 

6. Investments vary in their transferability. 

Suppose that an investor in New York holds a note 
secured by a mortgage on a farm in one of the western 
states. In some of the states such a note is not transfer- 
able at all. Even if the laws are such as to permit the sale 
of the note to a third party, the holder would find difficulty 
in disposing of it. The buyer would need to know some- 
thing of the value of the property pledged as security and 
this he might be unable to ascertain without examining it 
himself. The bonds of a small manufacturing or mercan- 
tile corporation in one of the minor cities would more easily 
find buyers in distant financial centers. Even these, how- 
ever, would ordinarily be difficult to dispose of. The bonds 
of a great railway or of an industrial consolidation always 
find a ready sale. One who invests in a Pennsylvania 
Railway or a United States Steel Corporation bond knows 
that he can at any time find some one who will be ready 
to buy it from him. 

7. The productiveness of an investment is measured by 
the ratio between its return and its market value. Different 
classes of investments vary widely in productiveness. 

It is, perhaps, straining the meaning of words to speak 
of a mortgage note or a corporation bond as being " pro- 



OTHER FINANCIAL INSTITUTIONS 309 

ductive." There is, however, reason to distinguish between 
the securities that yield an income and those that yield 
none, and the business world has drafted the words " pro- 
ductive " and " unproductive " into this service. We may 
safely accept the terms, as we are in no danger of falling 
into the error of regarding notes and bonds as actually pro- 
ductive, in the physical sense of the term. 

We must distinguish between nominal productiveness 
and real productiveness. A bond of $100 face value may 
yield $4 per annum. The nominal productiveness of capi- 
tal invested in such a bond is four per cent. But per- 
haps the bond may be purchased in the market for $80. 
In such case the real productiveness of capital invested in 
the bond is five per cent. A $100 share of stock paying 
dividends of ten per cent on its par value may sell at $200. 
The real productiveness of capital invested in such a stock 
is no greater than that of capital invested in the four per 
cent bond. 

We need not concern ourselves here with nominal pro- 
ductiveness. Whether such productiveness is high or low 
is a matter dependent upon the volume of securities cover- 
ing a specific earning power, and this volume is arbitrarily 
fixed. Real productiveness varies widely. Some invest- 
ments yield only two per cent ; some yield ten per cent or 
even more. 

8. The principal cause of variation in the productiveness 
of investments is risk, real or imagined. 

The bonds issued by the United States government 
yield less than two per cent on the capital represented by 
their market value. Bonds issued by the government of 
Santo Domingo, before the time of American intervention 
in the affairs of that country, often yielded as much as 
twelve per cent on their market value. Practically the only 
reason for the great difference in productiveness was the 
difference in security. The bonds of the several states 



3io 



INTRODUCTION TO ECONOMICS 



vary considerably in productiveness, and the bonds of 
municipalities display yet greater variety. The greatest 
variations in productiveness are to be found in corporation 
stocks, for here risk is greater than in the case of most 
classes of bonds. 

Although there may be no real difference in risk between 
two investments, if it is commonly believed that there is 
such a difference, this belief is reflected in the productive- 
ness of the respective investments. The bonds of Japan 
may be as safe as those of the United States ; but this is 
not generally believed to be true. For this reason invest- 
ments in Japanese bonds are more than twice as productive 
as investments in United States bonds. 

9. The productiveness of investments varies with their de- 
gree of transferability. 

As a rule, the greater the transferability of a form of 
investment, the lower will be its productiveness. Few in- 
vestors are absolutely certain that they will not at some 
time desire to regain control of their funds. They will 
therefore take at par a bond that is easily disposed of 
rather than one of equal security and equal nominal pro- 
ductiveness which they might find difficulty in selling. 
Consequently, the price of bonds of the former class will 
generally be higher than that of bonds of the latter class. 
A hundred dollars invested in the former class of bonds 
will yield a lower rate of interest than a hundred dollars 
invested in the latter class. 

The bonds of a great industrial corporation are usually 
less productive than those of a small one, on account of the 
greater transferability of the securities of a well-known 
business concern. Most classes of bonds furnish less pro- 
ductive investments than small real estate mortgages, be- 
cause the latter can with difficulty be transferred. 

10. The placing of capital may be effected by direct arrange- 
ments between the capitalist and the enterpriser or through 
the intermediation of a broker or other middleman. 



OTHER FINANCIAL INSTITUTIONS 311 

Where economic conditions are simple, as in an agricul- 
tural district or in a small town, the placing of capital may- 
be effected through direct arrangements between those who 
need capital and those who have it to spare. The moral 
character and business capacity of an enterpriser is easily- 
ascertained by those who wish to place their capital. A 
man who wishes to borrow capital can easily establish re- 
lations with those who have capital to lend. Even in such 
simple conditions, however, the individual borrower or 
lender is often at a disadvantage. The former may fail to 
meet the men who are ready to lend at the lowest interest 
rate ; the latter may fail to find the safest and most pro- 
ductive investments for his capital. Hence the need for a 
middleman, to bring together borrower and lender, enter- 
priser and capitalist. As industrial conditions become more 
complex, the need for the middleman becomes more in- 
tense. It would be quite impossible for the small capitalist 
of a city like New York or London to search out the most 
productive investments afforded by the business of such 
a city, were there no men who made it their business to 
bring capitalist and enterpriser together. 

The men who perform this function may employ either 
of two methods. They may act as mere agents, in behalf 
of lender or of borrower or of both. Thus in some towns 
there are men who undertake, for a fee or " commission," 
to place any man who wishes to borrow in relations with 
men who have capital to lend. The function may, how- 
ever, be performed in another way. Men with some capi- 
tal of their own may hold themselves in readiness to 
borrow any capital that is offered for a definite period of 
time, trusting to the chance that they will be able to lend 
it again on more advantageous terms. The difference be- 
tween the interest received and the interest paid represents 
the profits of the middleman. This, we have seen, is the 
method employed by the bank in its proper field. 



312 INTRODUCTION TO ECONOMICS 

The distinction which we have drawn between the two 
methods of placing, or marketing, capital, finds its ana- 
logue, we readily see, in a similar distinction in the methods 
of marketing commodities. A manufacturer may employ 
an agent, at a fixed, commission, to bring his wares before 
the consuming public, or he may sell them to a merchant, 
who undertakes the responsibility of disposing of them to 
consumers. 

11. In the great modern commercial centers the placing of 
capital is effected largely through the stock exchanges — mar- 
kets for the purchase and sale of securities. 

Under modern conditions an enormous amount of capi- 
tal is represented by the bonds of nations, states, and mu- 
nicipalities and of private corporations, as well as by the 
stocks of corporations. A government may issue several 
hundred millions in bonds, all yielding the same return 
and having the same security, and private corporation 
issues of bonds and stocks are sometimes of equal magni- 
tude. A person wishing to invest in a particular issue of 
government or corporation securities leaves an order with 
a broker to purchase such securities for him. A person 
wishing to regain control of capital invested in securities 
leaves them with a broker with orders to sell them. Natu- 
rally, the brokers dealing in stocks and bonds establish the 
custom of meeting at a fixed place, where those who have 
orders to buy may meet those who have orders to sell. 
Such a meeting-place, or market, is known as a stock 
exchange. For convenience, each exchange makes rules 
which brokers doing business there must observe. In their 
details these rules do not concern us here ; in principle 
they are designed to insure effectiveness and fair dealing. 

12. Since securities dealt in on the exchanges fluctuate in 
value, profits may be secured through buying when such se- 
curities are cheap and selling them when dear. Business of 
this nature is termed speculation. 



OTHER FINANCIAL INSTITUTIONS 313 

Practically all the securities dealt in on the exchanges 
are constantly fluctuating in price. The bonds of a country 
like the United States are unusually stable in value, yet a 
hundred-dollar bond is somewhat cheaper at one time than 
at another. If the United States should become involved in 
a war, the price of its bonds would decline, because of the 
probability of new issues. Even the rumor of a war, how- 
ever slight its foundation, may affect adversely the price of 
a nation's bonds. The bonds of a city may decline in value 
if the city government announces its intention of undertak- 
ing improvements on a large scale. The price of bonds of 
railway and industrial corporations is affected by every 
change in business conditions. Price fluctuation is still more 
common in the case of stocks. It is not unusual for the price 
of a given stock to decline from $150 per share to $60 per 
share within a single year. Suppose that a company has 
been formed to exploit gold mines in Alaska. Its shares 
are offered on the market ; we have read glowing accounts 
of the prospects of the company, but whether these ac- 
counts are reliable or not we cannot say. The company 
may earn enough to pay enormous dividends; it may earn 
nothing. What is more natural than that opinion as to 
the value of the stock should undergo frequent changes, 
and that the price of the stock should fluctuate accordingly. 

In view of the constant fluctuation in securities, it is 
natural that some men should make it their business to 
buy stocks when they appear to be cheap, with the purpose 
of selling them when prices rise. This is one of the numer- 
ous forms of speculation. The buyers of stocks and bonds 
are commonly divided into two classes — investors and specu- 
lators. The former class buy chiefly with the purpose of 
enjoying a permanent income from the securities purchased; 
the latter, chiefly with the hope of profiting from a rise in 
price of the securities. 

13. The speculator provides enterprises which have not 



314 INTRODUCTION TO ECONOMICS 

yet demonstrated their power to yield an income with the 
capital necessary for carrying on business. 

Naturally, the speculative buyer deals commonly in the 
securities that show great fluctuations in price, while the 
investor prefers the securities that have a comparatively 
steady price. Now, it is the securities of new companies 
that are most likely to fluctuate in value. After a com- 
pany has been in operation for a number of years, its nor- 
mal earning power becomes established, and the real value 
of its securities becomes fairly well settled. Thus there 
is a constant progress of securities from the speculative class 
to the investment class. 

We can now see what one of the economic functions of 
stock speculation must be. So long as the success of a 
company is in doubt, the cautious investor will have noth- 
ing to do with it. Men who are willing to take risks 
— speculators — buy the securities of such a company, with 
the expectation of selling them later at a profit. In so do- 
ing they furnish the company with the funds necessary for 
carrying on business operations. If the company succeeds, 
and demonstrates its power to produce a large and steady 
income, its securities acquire a stability of value fitting 
them for purposes of permanent investment. The specu- 
lators, in such cases, gain large profits. If the company 
is a failure, the speculator bears the loss. 

It is of course true that stock speculation offers great 
opportunities for sharp practice. A group of speculators 
holding the stock of a gold-mining company may succeed 
in placing in circulation deceptive accounts of the prospects 
of the company, and so manage to dispose of their holdings 
to the unwary at unreasonably high prices. A group of 
speculators, desiring to purchase certain stocks at a low 
price, may circulate rumors of impending disaster, and so 
create a panic among holders of stocks. Nevertheless, it is 
to be borne in mind that the speculative buyer of stocks per- 



OTHER FINANCIAL INSTITUTIONS 315 

forms a very important economic function in furnishing 
capital for enterprises the success of which is still in doubt, 
but which may eventually prove to be highly profitable. 
The speculator stands in the position of a middleman be- 
tween the company which needs capital and the cautious 
investor. 

14. When a company seeks to raise capital through an 
issue of securities, it may place orders with brokers to 
sell the securities for what they will fetch, or it may make, 
with an association of wealthy persons, an agreement accord- 
ing to the terms of which the association assumes responsi- 
bility for the sale of the securities at a definite price. Such 
an association is called an underwriting syndicate. 

Let us suppose that a great railway desires to raise about 
$50,000,000 by a new issue of four per cent bonds. It 
may place orders with brokers to sell the bonds at what- 
ever price they will command. The bonds of the railway 
which are already outstanding may be selling above par, 
but no one can say exactly what effect on the price of 
bonds the new issue will have. Possibly the bonds will be 
taken by investors at par; possibly the price will fall to 
$85 per hundred dollar bond. Moreover, it may take a 
long time before all the bonds are taken by speculators or 
investors. The railway company, however, desires a 
definite amount of capital at a definite time, and cannot 
afford to experiment. So its agents may make an arrange- 
ment with a group of financiers whereby the latter agree 
to insure the sale of the entire issue at $95 per hundred 
dollar bond. The bonds are then placed on sale at, say, 
$100. If the investing public takes the bonds at this 
price, the group of financiers, or "underwriting syndicate," 
gains a profit equal to the difference between the price to 
the public and the price agreed upon between the railway 
company and the syndicate. If the public refuses to buy, 
the syndicate is compelled to take the issue of bonds at 



316 INTRODUCTION TO ECONOMICS 

the price agreed upon — $95. Possibly the syndicate will 
be able to dispose of the bonds later on favorable terms ; 
possibly it will in the end be compelled to sell them at less 
than the price it has paid. 

Where the securities underwritten by a syndicate are 
of a more speculative character, as for example the stocks 
of a new industrial corporation, the difference between the 
price placed upon securities offered to the public and the 
price to the syndicate is much greater. The possible profits 
of the syndicate are much greater ; but so also are the pos- 
sible losses. 

15. An investment company is a company which purchases 
and holds stocks, bonds, mortgages, etc., the income of which 
is distributed as dividends among its own shareholders. 

A company may be formed for the sole purpose of deal- 
ing in the securities of other companies. Such a company — 
which we may call an investment company — places its stock 
upon the market, and invests the proceeds of the sales of such 
stock in the stocks and bonds of banking, railway, franchise, 
and industrial corporations, in government bonds, or in real 
estate mortgages. The interest and dividends from such 
investments make up the gross profits of the investment com- 
pany. From these profits are deducted the expenses of ad- 
ministering the company ; the remainder may be distributed 
among its stockholders as dividends. The advantages of 
such a company are obvious. It can employ men who are 
thoroughly familiar with the securities market to purchase 
stocks and bonds when the condition of the market is 
favorable. Since it purchases on a larger scale than the 
ordinary investor, it may participate in underwriting syndi- 
cates, and so obtain securities at a lower price than the 
outside investor must pay. It may distribute its invest- 
ments so that when some of them fail to yield the expected 
returns, others may yield unusually large returns. Thus 
the stockholders of the investment company are made 



OTHER FINANCIAL INSTITUTIONS 317 

more certain of a steady income than they would be if they 
invested their funds directly. 

Further, the investment company may deal in securities 
of undoubted value, which are nevertheless not well enough 
known to be easily transferred. There is no reason why the 
investment company should ever part with such securities. 
It may purchase mortgage notes which never would find a 
purchaser on the general market. As we have seen, the 
non-transferable investments yield, as a rule, higher returns 
than those that are easily transferred. Accordingly, the 
man who invests his funds through an investment company 
enjoys the higher income that non-transferable investments 
yield ; at the same time, he can at any time regain control 
of his funds through the sale of his stock in the investment 
company. 

From an economic point of view, the investment com- 
pany is a device which serves to direct capital to the more 
productive channels. In present-day business it has largely 
been diverted to another purpose, — that of stifling competi- 
tion. Let us suppose that in a given territory two railways 
are actively competing for business. Neither can charge 
as high rates as it could if it enjoyed a monopoly. Now, 
let us suppose that an investment company buys up a major- 
ity of the stock of both railways. It can then appoint the 
directors of both railways, and require them to adopt poli- 
cies which enable each to fix high charges for service. In 
this way the earnings of the railway companies, and hence 
of the investment company, are increased. Hostile federal 
legislation, it is true, has limited the efficacy of the invest- 
ment company as a means for destroying competition be- 
tween railways ; but the same device is widely employed in 
the case of manufacturing corporations. 

16. The savings bank performs the same function for the 
small investor that the investment company performs for the 
large one. 



318 INTRODUCTION TO ECONOMICS 

It is only persons possessing at least a moderate amount 
of free capital who can purchase with advantage investment 
company shares. Persons who have no other resource than 
their daily labor need to save some part of their income 
against sickness, old age, or unemployment; and these sav- 
ings should be placed where they may at once begin to earn 
interest. The artisan who saves $5 a month cannot be 
expected to keep the money on his premises until he has 
accumulated enough to buy a share of stock. This would 
involve keeping part of his savings idle for perhaps twenty 
months. It would, moreover, expose such savings to the re- 
current temptation to spend. Hence the need of an institu- 
tion which will accept savings deposits, however small, pay- 
ing interest on them from the beginning, and which will 
return them to the depositor upon reasonable notice. Such 
an institution is the savings bank. 

Unlike the commercial bank, described in the last chap- 
ter, the savings bank can depend upon a certain perma- 
nence of deposits. Men who intrust their funds to such an 
institution do so, as a rule, with the expectation of leaving 
them for an indefinite time, to earn interest. The rules 
under which a savings bank operates may of themselves 
insure a reasonable degree of permanence of deposits. De- 
positors are often required to give some days' or weeks' 
notice of intention to withdraw deposits. Furthermore, 
interest is usually allowed only at the end of six months' 
periods ; withdrawal at any time within such periods involves 
the forfeiture of accrued interest. 

Some part of the deposits of a savings bank must be 
kept as a cash reserve, to meet possible withdrawals, but 
this reserve need not be large. The remainder of the de- 
posits may be invested. State laws generally specify the 
classes of investments that a savings bank may make, with 
a view to insuring the depositor against loss through inse- 
cure investments. Real estate mortgages, federal, state, 



OTHER FINANCIAL INSTITUTIONS 319 

and municipal bonds, are the favorite investments of such 
institutions. The real estate mortgages present the advan- 
tages of security and a high degree of productiveness; 
government bonds, while yielding low returns, are easily 
convertible into cash whenever an unusual volume of with- 
drawals renders this necessary. 

Savings banks may be organized as mutual associations, 
in which case all the profits from investments are distrib- 
uted among the depositors as interest. They may be organ- 
ized as joint stock associations; in such case the excess of 
earnings above stipulated interest to depositors is distrib- 
uted among the stockholders as dividends. The latter form 
of organization prevails in the West, the former in the East. 
In many foreign countries the place of the mutual savings 
bank is taken by municipal and postal savings banks. In 
general, it is recognized that the proper function of the 
savings bank is to promote thrift among the poorer classes, 
not to afford an opportunity for profit to the well-to-do. 
Hence the small depositor is frequently given the prefer- 
ence over the large depositor, receiving a higher rate of 
interest. In many cases the size of the individual deposit 
is narrowly limited. 

17. The building and loan association is a form of invest- 
ment company which limits its field to small loans on real 
estate security. 

A financial institution which in some parts of the coun- 
try takes the place of the savings bank in promoting saving 
among the working classes is the building and loan associa- 
tion. Each member of the association purchases a certain 
number of shares of "stock," paying for them in monthly 
installments. If at any time he wishes to withdraw, the 
association returns to him the sums which he has paid in, 
with or without interest, according to the time that has 
elapsed since his first payment. If a member desires to 
build a house, he may borrow from the association a sum 



320 INTRODUCTION TO ECONOMICS 

not exceeding the par value of the stock in the association 
which he holds. As security for the loan, he gives a mort- 
gage upon the house which he builds with the aid of the 
loan. He further binds himself to make monthly payments 
to the association which represent interest on the loan, 
plus some part of the principal. Without entering upon 
the details of the organization of such an association, we 
can see that its purpose is to collect sums of capital from 
persons of small means, with the purpose of loaning them 
to other persons of small means who desire to own homes. 
The latter class pay the interest that the former class 
receive. 

18. From the financial point of view, the life insurance 
company is a modified form of investment company. The 
returns from investments are for the most part made over to 
the policy holders. 

One further institution requires notice here : the life 
insurance company. From a financial point of view, the 
life insurance company is a device for accumulating sav- 
ings which shall be returned, not to the man who saves, 
but to his heirs at his demise. Some of the insured, it is 
true, die long before the sum of the premiums they have 
paid equals the sum that the insurance company has 
agreed to pay at their death. On the average, however, 
the insured live long enough so that their premiums, to- 
gether with the earnings of the capital which those pre- 
miums fprm, are at least equal to the sums which the 
insurance company pays out in death claims. 

It is obvious that in a country like the United States, 
where life insurance is exceedingly common, immense sums 
of money must be collected by the companies every year, 
to be held as a reserve against death claims. As the busi- 
ness of life insurance is steadily growing, the funds accu- 
mulated by these companies are also increasing. The 
annual receipts of practically every important life insur- 



OTHER FINANCIAL INSTITUTIONS 321 

ance company exceed the annual disbursements. Accord- 
ingly, a life insurance company may invest its funds 
without much regard to the possibility of turning its invest- 
ments into cash at short notice. It is important, however, 
that the business should be conducted in a conservative 
manner, since the failure of an insurance company would 
be a more widely felt calamity than the failure of almost 
any other business enterprise of equal magnitude. The 
loss would be borne in the end largely by the dependents 
of propertyless men. 

The reserves of life insurance companies are largely 
invested in real estate mortgages, in state and municipal 
bonds, and in the bonds of railway, commercial, and in- 
dustrial corporations. Stock investments have often been 
made by insurance companies, but the practice is now 
generally regarded with disfavor, since the values of stocks 
are likely to show a wide range of fluctuation. 

19. The mechanism for bringing investor and enterpriser 
together necessarily becomes more complex as industrial 
operations increase in magnitude. 

In a small village, the investor and the enterpriser enter in- 
to direct relations with each other. In a larger town, funds 
flow from the investor to the enterpriser through the inter- 
mediation of a broker. In a great city funds flow from 
the investor to the enterpriser through the intermediation 
of a series of brokers and a series of speculators ; often 
other functionaries, such as the underwriter and the in- 
vestment company, insert themselves in the chain connect- 
ing the two primary financial classes — the investor and 
the enterpriser. We shall understand this flow of funds 
better if we construct a diagram representing it in all its 
complexity : — 



322 INTRODUCTION TO ECONOMICS 

Stockholder Depositor Policy Holder 

Y Y Y 

Independent Investor Investment Co. Savings Bank Insurance Co. 

Y 

(Broker) 

Y 

Speculator 

\ 

(Broker) 

Y 

Underwriting Syndicate 

\ 

Industrial Enterprise 

In our diagram the broker is placed in parenthesis, be- 
cause he is nominally an agent for the investor or the 
speculator. The diagram is less complex than the reality, 
because it assumes that only one speculator figures in the 
chain, when in fact a security may pass from one specu- 
lator to another for years before its value becomes suffi- 
ciently stable to attract the interest of investors. 

20. Summary. 

In modern economic society there is a constant flow of 
funds from the capitalist class to the enterpriser class. 
The purchase or improvement of real estate, the financing 
of large business enterprises, and the extraordinary needs 
of governments give rise to the demand for long term in- 
vestment ; men retiring from active business life, endowed 
institutions, and persons accumulating capital against 
future needs furnish the supply of such funds. This flow 
of capital may be represented as the purchase and sale 
of stocks, bonds, and mortgage notes. 

Long term investments vary widely in security and 
transferability. As a rule, the greater the degree of secur- 
ity and transferability, the less the productiveness of an 
investment. 

The placing of capital may be effected through direct 
arrangement between the capitalist and the enterpriser, 



OTHER FINANCIAL INSTITUTIONS 323 

or through the intermediation of a broker or other middle- 
man. The broker may carry on his business independently, 
or he may join with other brokers in organizing a stock 
exchange. The purchasers of stocks and bonds may hold 
them for the income which they yield, or for a rise in price. 
In the former case the purchasers are classed as investors, 
in the latter, as speculators. When an enterprise is new, 
its securities are chiefly held by speculators ; when its 
business is well established, the securities are likely to pass 
into the hands of permanent investors. Thus the specula- 
tor appears in the light of an intermediary between the en- 
terpriser and the ultimate investor. 

Investment may be made through various institutions, 
instead of directly by the capitalist. The most important 
of these are the investment company, the savings bank, 
the building and loan association, and the life insurance 
company. These institutions are adapted to the peculiar 
needs of different classes of investors. They share in 
common the advantages of expert skill in the making of 
investments and of power to distribute investments in such 
a way as to minimize risk. 



CHAPTER XVIII 
INTERNATIONAL TRADE AND FOREIGN EXCHANGE 

1. All permanent trade rests upon differences in produc- 
tive powers. 

From early modern times, when men first began to 
think systematically upon economic subjects, a great deal 
of attention has been bestowed upon the exchange of 
goods between persons living under different governments, 
or international trade. It was for a long time believed (and 
it is still widely believed) that such trade differs radically 
in its nature from trade that is carried on within the limits 
of a single country. While the latter, it is generally ad- 
mitted, is an unmixed good, and ought to be encouraged, 
Or at any rate granted the most perfect freedom by govern- 
ment, the former, many believe, is often a doubtful blessing 
and ought to be closely scrutinized and regulated, and, 
under many circumstances, discouraged or even prohib- 
ited. Whether there is any justice in this distinction be- 
tween the two branches of trade is a question that we must 
defer to the next chapter. For the present, we are con- 
cerned with the conditions giving rise to international trade 
and the mechanism by which it is carried on. 

All permanent trade is based upon differences in char- 
acter of productive powers. To employ a simple example, 
drawn from the field of local trade, if A can make three 
pairs of shoes in a day while B can make only two, and B 
can cut two cords of wood in a day while A can cut only 
one, the basis for permanent trade between them exists. 
It will pay A to get all his wood from B, exchanging shoes 
for it. The assumed difference in character of productive 
powers may have originated in differences in natural apti- 
tudes or in differences in training. In either case the 

3 2 4 



INTERNATIONAL TRADE AND FOREIGN EXCHANGE 325 

difference in productive powers is the essential basis of a 
continuous interchange of commodities. 

But suppose that A can not only make more shoes in a 
day than B can make, but can also cut more wood. Does 
this supposition preclude the possibility of a permanent in- 
terchange of products between A and B ? Not at all. 
Suppose that A can make three pairs of shoes in a day or 
cut two cords of wood, while B can make only one pair of 
shoes, or cut only one cord of wood. With two days' work 
B can produce as much wood as A can with one ; with two 
days' work he cannot produce as many shoes as A can 
with one. Accordingly, it would pay him to offer A the 
product of a little more than two days of his own work at 
woodcutting, in exchange for the product of one day of 
A's work at making shoes. And it would pay A to accept 
the offer. B suffers under a disadvantage in either occu- 
pation, but his disadvantage is less in woodcutting than in 
shoemaking. A enjoys an advantage in either occupation, 
but his advantage is greater in shoemaking than in wood- 
cutting. Common sense, then, urges B to confine himself 
to cutting wood, A to making shoes. 

In the trade between inhabitants of one part of the 
earth's surface with those of another part, differences in 
personal aptitude and training of the kind assumed in the 
foregoing example are supplemented by differences of a 
more general nature. One region may have excellent min- 
eral deposits but lack fertile land for the growing of food ; 
another region may be quite devoid of minerals, but abun- 
dantly supplied with rich lands. In one region the char- 
acter of the population may be such as to fit it for kinds of 
work requiring skill and taste, but not such as to fit it for 
kinds of work requiring great muscular strength and endur- 
ance. In another region the population may be almost in- 
capable of acquiring taste and skill, although it is well 
fitted for labor demanding rude muscular power. Capital 



326 INTRODUCTION TO ECONOMICS 

may be plentiful and cheap in one region and scarce and 
dear in another. In this case industries requiring vast 
capital can be operated to greater advantage in the former 
region than in the latter. Land may be plentiful in one 
region, relatively to the population, and scarce in another. 
Industries requiring an extensive use of land will find their 
natural habitat in the former region. The populations of 
two regions, though differing little in fundamental charac- 
ter, may differ widely in their attitude toward particular 
forms of toil. They possess different habits, or, more 
properly, traditions of workmanship, which fit the one 
better for one kind of labor, the other for another. So 
long as any of these differences persist, there is obviously 
reason why there should be differences in the industries of 
the two regions. With adequate means of communication, 
trade between the two regions naturally arises. 

2. Economically considered, trade should be classified as 
local and interregional, not as domestic and international. 
The latter classification may, however „be regarded as practi- 
cally equivalent to the former. 

We have spoken of differences between regions, not 
differences between nations. From a purely economic point 
of view, trade is either local or interregional, not domestic 
or international. The trade between Belgium and the 
adjacent departements of France is economically of the 
same character as the trade between Rhode Island and Mas- 
sachusetts. The trade between California and Hawaii is 
of the same essential character as the trade between New 
York and Santo Domingo. From an economic point of 
view domestic trade is that which originates in such differ- 
ences in natural aptitudes and industrial training as may for 
a long time persist on the same soil. Differences in natural 
endowment, in general character of population, in rates of 
wages and interest, characterize interregional trade. As a 
rule, however, international trade is also interregional; 



INTERNATIONAL TRADE AND FOREIGN EXCHANGE 327 

hence the principles that apply to the latter may without 
serious qualification be applied to the former. Since the 
classification of trade as domestic and international is widely 
used, we shall accept it, in spite of its inaccuracy, in the 
following pages. 

3. Trade between two regions or nations may be based upon 
the fact that each one produces goods of a kind that cannot 
be produced within the boundaries of the other. 

In some cases the products of two regions are quite dis- 
similar. Neither region can produce the commodities 
which it receives from the other. Thus in the Middle Ages 
an important trade was carried on between Northern 
Europe and the Indies. The former region furnished furs 
and amber, the latter, spices and gems. A modern example 
of the same sort of trade is the exchange of iron and steel 
products for teas, coffee, and spices between England on 
the one hand, and the East Indies on the other. In general, 
the trade between countries in the temperate zone, on the 
one hand, and countries in the torrid zone, on the other, is 
largely of this character. Trade having this basis is nat- 
urally permanent ; with every reduction in costs of trans- 
portation it tends to increase. Decline in railway and 
ocean shipping charges places more and cheaper tropical 
products in our hands, and places more of our products in 
the hands of the inhabitants of the tropics. Furthermore, 
we are, as a people, gradually learning to appreciate the 
good qualities in tropical products that a short time ago 
we held in slight esteem ; and we may assume that a cor- 
responding evolution is taking place in the tastes of the in- 
habitants of the tropics. 

4. Each one of two trading nations may be able to produce 
all classes of commodities that are the objects of exchange be- 
tween them. In this case, the one is likely to enjoy greater 
relative advantages for the production of one class of com- 
modities ', the other for the production of another class. 



328 INTRODUCTION TO ECONOMICS 

More commonly one of the trading regions, or both, 
can produce both classes of commodities exchanged. The 
United States can produce both sugar and pork ; so also 
can Cuba. But the United States possesses exceptional ad- 
vantages for the production of pork ; for the production of 
sugar it is not especially well adapted. Cuba, on the other 
hand, has unsurpassed advantages for the production of 
sugar, but can produce pork with only a moderate degree of 
success. It is, therefore, natural that an exchange of prod- 
ucts between the two countries should take place. Were 
there no artificial hindrances to such exchange, we should 
adjust our production in such a way as to produce all 
the pork that Cuba needs, and Cuba would devote more of 
her productive resources to the growing of sugar for our 
consumption. 

5. Trade based upon differences in productive power aris- 
ing from differences in the character of two populations is 
permanent in character and tends to increase with improve- 
ments in transportation. 

Among the conditions upon which international trade is 
based, we mentioned differences in the essential character 
of the populations of trading regions. Such differences in 
character are difficult to define, since the characters of 
nations, as of individuals, are always thickly overlaid with 
custom and habit. Nevertheless, we may be quite sure 
that such differences exist. The German is not exactly the 
same kind of man as the Englishman, even if due allow- 
ance is made for acquired traits. Still less is the Japanese 
the same kind of man as the American. It is therefore 
safe to assume that in some of the manifold branches of 
industry the German will be superior to the Englishman, 
while in some he will be inferior. We may certainly as- 
sume that in some branches of industry the Japanese will 
be more successful than the American, while in other 
branches he will be less successful. 



INTERNATIONAL TRADE AND FOREIGN EXCHANGE 329 

Cotton can be grown successfully by the native popula- 
tion of Central Africa. The tedious labor under a tropic 
sun is more easily borne by the native blacks than it would 
be by persons of European descent. The manufacture of 
cotton cloth by modern methods requires a higher degree 
of intelligence, perseverance, and responsibility than the 
native African population possesses. This branch of the 
industry may better be carried on in a country like Eng- 
land, where the population has the required traits in a 
high degree of development. Accordingly, there is a 
natural basis for permanent trade between England and 
Central Africa. Trade based upon such essential differ- 
ences in national character also tends to increase in im- 
portance with improvements in the means of transportation 
and communication. 

6. International trade based upon differences in relative 
supply of land eventually loses a large part of its importance 
on account of the movements of population. 

Trade based upon differences in relative supply of land 
attained extraordinary proportions during the nineteenth 
century. The Old World, for the most part, was densely 
peopled ; in the New World population was sparse. It is 
a well-known fact that the largest output per workman of 
agricultural products is attained through the superficial cul- 
tivation of large areas. England may have lands that are 
naturally better adapted for the growing of wheat than the 
lands of Argentina. But it is hardly possible for one man 
cultivating twenty acres in England to produce as many 
bushels of wheat as one man cultivating two hundred acres 
in Argentina. 

In manufactures, on the other hand, density of popula- 
tion, instead of reducing productive efficiency, tends to in- 
crease it. Men who live in constant association are better 
fitted for the organized activity of the modern factory than 
are men who pass their lives in the isolation of the frontier. 



330 INTRODUCTION TO ECONOMICS . 

Hence an exchange of agricultural products for manufac- 
tures between the New World and the Old was in the nat- 
ural order of events. 

During the greater part of the nineteenth century trade 
between the United States and England was chiefly of the 
character just described. The United States possessed 
vast tracts of land for extensive cultivation ; England had 
a dense population well fitted for factory labor. Hence 
we exported foodstuffs and raw materials and imported 
manufactures. 

While trade upon this basis tends to increase with re- 
duction in costs of transportation, there is a counter tend- 
ency at work which in time checks it. Immigration flows 
into the regions rich in land; the natural increase of 
population in those regions is likely to be rapid. In the 
end such regions lose their peculiar advantages in the 
production of foodstuffs and raw materials, and gain in 
power to produce manufactures cheaply. Trade of the 
character under discussion may continue for centuries, but 
ultimately it decays. The United States still exports large 
quantities of foodstuffs and raw materials and imports 
manufactured goods. But these elements in our foreign 
trade no longer maintain their former supremacy. In an- 
other century the United States will doubtless import 
chiefly raw materials and foodstuffs from regions which 
remain sparsely peopled and export manufactures in 
exchange. 

7. International trade based upon differences in relative 
supply of capital is of waning importance, since capital 
flows easily from country to country. 

We need not dwell at length upon the trade that is 
based upon differences in the supply and cheapness of 
capital. So long as England was par excellence the land of 
capital, and so long as English capitalists were unwilling 
to invest their funds in foreign lands, there were many 



INTERNATIONAL TRADE AND FOREIGN EXCHANGE 331 

branches of manufacture that could be prosecuted with 
far greater advantage in England than in other countries. 
In practically every branch of manufacture, in fact, the 
interest on capital makes up a far larger proportion of the 
total expenses than in grazing, agriculture, lumbering, etc. 
It is easy to see, then, that English manufacturers, with 
interest at five per cent, enjoyed a decided advantage over 
American manufacturers, with interest at eight per cent. 
The English farmers and stockmen, it is true, also had an 
advantage in interest rates over their American competitors. 
But the advantage was of less relative importance and more 
easily offset by other factors in which the Americans en- 
joyed an advantage, such as cheaper land. 

Under present-day conditions no country can long hold 
a branch of trade merely through cheapness of capital. 
Like labor, capital tends to migrate to the less developed 
regions of the world ; its migration involves far less per- 
sonal sacrifice and far less cost. Furthermore, capital in- 
creases rapidly in the newer lands. If interest rates were 
much higher in the United States than in Great Britain, 
British capital would steadily flow into the former country ; 
and this influx of capital, added to the new capital con- 
stantly accumulating here, would tend to depress interest 
rates, until there remained no perceptible difference in the 
rates prevailing in the two countries. The trade based 
upon differences in capital supply may, therefore, be re- 
garded as transitory. 

8. International trade based upon differences in traditions 
of workmanship often manifests a high degree of perma- 
nence. 

In a region that has long been devoted chiefly to a given 
branch of industry, something that we may call a tradition 
of workmanship evolves. The best type of iron worker is 
not developed in a single generation. The mill that is 
manned with workers whose fathers and whose fathers' 



332 INTRODUCTION TO ECONOMICS 

fathers were reared in a world of iron manipulation pos- 
sesses a decided, though indefinable, advantage over the 
mill that is manned with workers whose antecedents were 
of the field or forest. Costly experiments in settling urban 
stock upon farms have demonstrated the soundness of the 
popular view that it takes generations to make a farmer. 
Still more important is the tradition of workmanship in in- 
dustries requiring a high degree of taste and skill. Where 
is the Occidental who can produce a true Oriental rug ? 

When other conditions are ripe, the population of any 
region may develop the tradition of workmanship neces- 
sary for the successful prosecution of any specific branch 
of industry. But no region can be expected to gain a su- 
periority in all lines. We may at some future time be able 
to make gowns as well as the French, and ivory toys as well 
as the Japanese. But there will always be objects of taste 
which we must buy from the French and the Japanese. 
Trade based upon such differences may, therefore, be 
treated as permanent in character. 

9. The foreign trade of modern nations is based upon a 
combination of differences, some of a permanent and some of 
a transitory nature. 

In the foreign trade of a great country like the United 
States or Great Britain it is natural that we should find 
one part having one underlying basis, another part another 
basis. In many cases the exportation or importation of a 
commodity arises from a combination of several of the 
causes which we have described as bases of trade. The ex- 
portation of iron and steel products from Great Britain to 
India is based upon the fact that Great Britain has vastly 
superior deposits of iron ore and coal, cheaper capital, and 
a population better fitted than that of India for metallurgi- 
cal industry and possessing a superior tradition of work- 
manship. The exportation of wheat from the United 
States to England is based solely upon the greater abun- 



INTERNATIONAL TRADE AND FOREIGN EXCHANGE 333 

dance of land, relatively to the population, in the former 
country. The importation into the United States of French 
articles of taste may be due in part to superiority of the 
French national character, in this respect; but it is un- 
doubtedly due in large part to a superior tradition of work- 
manship on the part of the French. With the lapse of 
time we shall cease to export many of the commodities we 
now export; many of the commodities which we now im- 
port will be produced in this country. 

10. A country may import commodities for the production 
of which it is better fitted by nature than are the countries 
which export these commodities. Such a proceeding is 
economical when the first country enjoys even greater advan- 
tages in the production of other commodities than the other 
countries enjoy. 

We have, hitherto, considered only cases in which each 
one of two trading regions possesses unique, or at any rate 
superior, advantages in the production of the commodities 
which it exports. Under certain conditions trade may be 
advantageous even when this is not the case. To use a 
time-honored illustration, let us suppose that the United 
States, by reason of its natural wealth and the character of 
its population, is in a better position to produce both wheat 
and steel than England. A day's labor will produce more 
of either commodity in America than in England. Yet it 
may be profitable for the United States to buy its steel 
from England, giving wheat in exchange. We will assume 
that in America a day's labor will produce four bushels of 
wheat or two hundredweights of steel, while in England a 
day's labor will produce one bushel of wheat or one hun- 
dredweight of steel. Disregarding the costs of transporta- 
tion, it would be profitable for America to offer England 
three bushels of wheat in exchange for two hundredweights 
of steel, and it would be profitable for England to ac- 
cept the offer. America would thus obtain two hundred- 



334 INTRODUCTION TO ECONOMICS 

weights of steel for three fourths of a day spent in wheat 
growing, instead of spending a whole day's labor in making 
the steel. England would obtain three bushels of wheat 
through two days' labor spent in steel making, instead of 
spending three days' labor producing the same amount of 
wheat. America possesses an advantage in either industry, 
but her advantage is greater in wheat growing. England 
is at a disadvantage in either branch of production, but 
her disadvantage is less in steel making. It is therefore 
natural, under the assumed conditions, that America should 
make a specialty of wheat production, England of steel 
making, and that the two countries should carry on a 
mutually profitable trade. 

This case is obviously analogous to the case of ex- 
change between shoemaker and woodcutter which we em- 
ployed in the early part of this chapter. But while any 
person of ordinary intelligence can see how it may be prof- 
itable for an efficient shoemaker to hire a man less fitted 
than himself for woodcutting to supply him with wood, it 
appears to be beyond the comprehension of most ordinary 
men, and many extraordinary ones, that a country can prof- 
itably pursue the same business policy. Since a day's 
labor does actually produce more steel in the United States 
than in England, many men believe that it must be unprofit- 
able for us to buy steel from England. Obviously, they 
fail to consider the possibility that we may have other in- 
dustries so much more productive than those of England that 
we cannot afford to divert our labor to the making of steel. 

11. From the fact that a country has greater natural ad- 
vantages for the production of a commodity than other 
countries enjoy ', it does not necessarily folloiv that the money 
cost of the commodity is lower in the former country than in 
the others. 

Let us look at the matter from another point of view — 
that of prices and money cost of production. The men who 



INTERNATIONAL TRADE AND FOREIGN EXCHANGE 335 

engage in the business of importing and exporting commodi- 
ties do not inquire into underlying bases of trade. Their 
inquiries begin and end with prices. Is steel cheaper in 
England than in America ? If so, and if the difference is 
great enough to pay the cost of transportation, they import 
the steel, unless they are prevented by government from 
doing so. Is wheat cheaper in America than in England ? 
If it is enough cheaper to pay the costs of transportation, 
they export it. 

But why should steel be cheaper in England than in 
America, while wheat is cheaper in the latter country ? 
Prices, we know, tend to equal money cost of production ; 
therefore we may assume that it costs less to produce steel 
in England, wheat in America. Our inquiries cannot stop 
here, however, for we must know why it costs more to pro- 
duce the one commodity in the one country, the other com- 
modity in the other country. 

Ask a steel manufacturer why it costs more to produce 
steel in this country than in England, and he will probably 
reply, " Labor is dearer." The pay of English steel workers 
is, indeed, lower than that of steel workers in America, but 
so also is the pay of English agricultural laborers lower than 
that of farm hands in America. It is, therefore, plain that it 
is not the low wages, absolutely considered, that give the 
British steel manufacturer an advantage, but the low wages, 
relatively to the productive efficiency of the workmen. 
Low wages do not make British agriculture prosperous, be- 
cause the productive efficiency of laborers in that industry 
is low, relatively to wages. The disadvantage of the British 
steel industry as compared with the American is less than 
the disadvantage of British agriculture as compared with 
American. 

12. It is profitable to import a commodity whenever labor 
and capital engaged in its production yield less than the same 
agents would yield in other fields. 



336 INTRODUCTION TO ECONOMICS 

We shall get a clearer view of the situation if we stop 
to consider the principles determining cost of production. 
Wages and interest are the chief constituents of cost of pro- 
duction ; but we will fix our attention upon wages alone. 
In earlier chapters we saw that wages are determined by 
the marginal productivity of labor. Now, let us suppose 
that one trading region has a vast extent of fertile land and 
a sparse population. Only the best lands are tilled and 
these in a superficial way. Add a thousand laborers to the 
population. How much can they produce? Perhaps five 
bushels per man a day. This amount of wheat, or the price 
of it, they can demand as wages ; all other equally efficient 
workmen will get as much, but no more. Another trading 
region has, let us say, a dense population and little land. 
All the good lands are carefully tilled; most of the poor 
lands are also under cultivation. Add a thousand men to the 
working population. It is highly improbable that these men 
will increase the product by five bushels per man per day. 
Rather, we may assume that the daily product of a man is 
only one bushel. And this, or its price, is all that any 
equally efficient laborer in the society can get. 

If the two regions are in easy communication with each 
other, the price of wheat in the one will be the same as the 
price in the other, allowance made for the cost of shipping 
wheat from the one to the other — a few cents per bushel, we 
will assume. This means that money wages will be much 
higher in the region which is sparsely settled than in the 
region where population is dense. 

Now, let us suppose that each region possesses ores and 
coal, but that the deposits of the sparsely settled region are 
so much the richer that a day's labor will produce from them 
twice as much steel as a day's labor will produce from the 
deposits of the densely settled region. Enterprisers of the 
former region will have to pay miners, furnacemen, etc., at 
least as much as they could earn in agriculture — the price 



INTERNATIONAL TRADE AND FOREIGN EXCHANGE 337 

of five bushels a day. Enterprisers in the region of dense 
population will also pay wages gauged by the returns to 
agricultural labor — the price of one bushel a day. A simple 
calculation will show that steel manufacturers in the region 
of dense population can produce steel much more cheaply 
than their competitors in the other region. 

In order to make our example correspond more closely 
with reality, we should need to substitute, for steel mak- 
ing only, a wide range of industries, mainly manufactur- 
ing ; for wheat raising we should substitute a wide range 
of industries, mainly extractive. We might then say, with 
perfect truth, that in a sparsely settled region the margi- 
nal productivity, and consequently the wages of labor, are 
likely to be so high that manufactures cannot be carried 
on profitably in competition with a densely settled region, 
where the marginal productivity of labor, and hence wages, 
are low. American manufacturers of iron and steel prod- 
ucts have for a century been forced to pay higher wages 
than English manufacturers, largely because the produc- 
tivity of labor in agriculture was so much higher here 
than in England. 

13. Trade between different countries is essentially barter. 

In early times, interregional trade, like all other forms 
of trade, was carried on through barter. The Phoenician 
merchant, we may safely assume, carried to each port 
commodities that he thought would be in demand there, 
and bartered them for commodities which he desired. In 
a later stage money was employed, but chiefly for effect- 
ing exchanges within a single locality. The artisan mer- 
chants of the mediaeval Hanse towns trading with England 
carried cloth and other wares to London and exchanged 
them for wool and other English products. Doubtless 
when in England the Hanse merchants often first ex- 
changed their wares for local currency, and exchanged 
the currency in turn for goods to carry back to Germany. 



338 INTRODUCTION TO ECONOMICS 

From the point of view of the two trading regions, the trade 
was an exchange of goods for goods, or barter, in spite of 
the employment of currency in England. 

In a later stage the importation of goods is partly di- 
vorced from the exportation of goods. Men having goods 
that they believe will fetch a high price in a foreign mar- 
ket ship them abroad, expecting to receive the price of the 
goods in the form of gold and silver. Men wishing to 
buy foreign goods send gold and silver in payment for 
them. Hence, exportation and importation of the precious 
metals may be often carried on concurrently, at a consider- 
able risk and expense. Here obviously is opportunity for 
the development of a system of set-offs, to reduce the 
transmission of the precious metals between the two trad- 
ing regions to a mere settlement of balances. By this 
system, which long ago reached a high degree of develop- 
ment, international trade is reduced practically to barter — 
exchange of commodities for commodities. 

14. The use of gold in international payments is largely 
obviated by the employment of bills of exchange. 

Let us suppose that A, a New York exporter, has sold 
10,000 bushels of wheat to X, a Liverpool importer, at 
the price of $1 a bushel. If he wishes the $10,000 deliv- 
ered to him at New York, in gold, he must, of course, pay 
freight and insurance on it. This will cost about $3 for 
every $500, or $60 for the entire sum. 

But suppose that after shipping the wheat, and before 
giving orders for the delivery of the gold, he meets B, a 
New York importer, who is about to order $10,000 worth of 
woolen goods from Y, a Liverpool exporter. If B were to 
ship the $10,000 in gold to Liverpool, it would cost him 
$60 for freight and insurance. Now, if A will give B an 
order instructing X to pay Y the $10,000, instead of re- 
mitting it to himself, B can pay A the $10,000 that he 
would otherwise have remitted to Y. Both debts will be 



INTERNATIONAL TRADE AND FOREIGN EXCHANGE 339 

extinguished by such an arrangement, and both A and B 
can save $60 by it. 

Such an order as we have assumed that A gives to B, re- 
questing X to pay Y a certain sum originally due to A, is 
known as a bill of exchange. Such a bill may be payable 
as soon as it is presented to the person upon whom it is 
drawn, or it may be payable after the expiration of a 
period of time — twenty, thirty, sixty days. In the for- 
mer case it is a " sight bill," in the latter a " time bill." 
Time bills usually bear interest — a fact that assimilates 
them to other credit instruments, but has no bearing on 
the principles of exchange. We shall therefore assume 
that bills of exchange are sight bills only. 

In our example it appeared that both A and B gained 
$60 by the arrangement. Now, if B had been unwilling, 
for some reason, to give A $10,000 for the latter's bill of 
exchange, A might have taken less. It would have been 
more profitable for him to take $9950 than to incur the 
expense of importing the gold. If B had offered $9940, 
it would have been a matter of indifference to A whether 
he sold his bill to B or imported the gold. $9940 is evi- 
dently the very lowest price at which the bill would be 
sold. On the other hand, if A had been unwilling to 
part with his bill for just $10,000, B might have offered 
more, for he could better have afforded to pay $10,050 
for the bill than stand the expense of exporting gold. If 
A had demanded $10,060, it would have been a matter of 
indifference to B whether he bought the bill or shipped 
the gold. $10,060 is, then, the very highest price that a 
$10,000 bill can be made to fetch. 

15. Bills of exchange sell at par when the supply of them 
just equals the demand. When the supply is less than the 
demand, they rise above par ; when the supply exceeds the 
demand \ they fall below par. 

When a bill of exchange sells for just its face value, it is 



34Q 



INTRODUCTION TO ECONOMICS 



said to be at par ; when for more or less, it is above or below 
par. We have now to inquire under what conditions bills 
will be at par, or above or below par. 

If the importer whom we designated as B thinks that 
the chances are good that he can find other exporters be- 
sides A who are anxious to dispose of bills of exchange, he 
is likely to offer less than par for A's bill. If one of the 
holders of bills will not sell at a low price, another probably 
will. If, on the other hand, A thinks that he can easily 
find other persons besides B who have payments to make 
abroad, and who are anxious to purchase bills for the pur- 
pose, he is likely to hold his bill at a price above par. In 
general terms, when the volume of bills offered for sale 
appears to exceed the volume of remittances to be made to 
a foreign center, bills fall below par. When the volume of 
bills appears to be inferior to the volume of remittances to 
be made, bills rise above par. In the former case, each 
holder of a bill knows that some bills cannot be sold at 
all ; their holders will have to go to the expense of import- 
ing specie. Rather than be left in this position himself, he is 
willing to sell his bill at less than its par value, provided that 
the price offered is not so low that to bear the cost of import- 
ing specie would be a lesser evil. In the latter case each 
person having remittances to make knows that some men 
will have to go to the expense of exporting specie. Hence 
each one will offer more than its par value for a bill of 
exchange. 

16. When all the payments that one trading region must 
make to another equal the payments to be made by the latter 
region to the former ', the supply of bills equals the demand, 
and exchange is at par. 

We must now endeavor to determine the conditions un- 
der which the volume of bills equals, is superior to, or in- 
ferior to, the volume of remittances. We shall assume 
that the relations between the United States and Great 



INTERNATIONAL TRADE AND FOREIGN EXCHANGE 341 

Britain are carried on without regard to relations with 
other countries, and that American business is all handled 
through New York, British through London. 

The United States, we will assume, exports in one year 
products worth $500,000,000 to Great Britain, and Great 
Britain exports products worth $250,000,000 to the United 
States. Under the head of exports and imports, we shall 
have bills on London aggregating $500,000,000, and remit- 
tances to make aggregating only $250,000,000. 

Citizens of the United States still owe vast sums to citi- 
zens of Great Britain ; citizens of Great Britain owe lesser 
sums to citizens of the United States. Interest on these 
debts will be transmitted by way of exchange. Let us say 
that Great Britain must pay us $5,000,000, while we must 
pay Great Britain $75,000,000. This will add $5,000,000 
to the total volume of bills, and $75,000,000 to the aggre- 
gate of remittances. 

Some American borrowers are paying off their debts to 
British capitalists ; others are borrowing fresh capital. The 
sum of payments at present probably greatly exceeds the 
sum of new loans. We will put the former at $ 1 30,000,000, 
the latter at $25,000,000. Under this head, then, we may 
add $25,000,000 to the volume of bills, $130,000,000 to the 
volume of remittances. 

Americans living or traveling in England must have 
their incomes sent them from here; Englishmen living or 
traveling here must have their incomes sent from England. 
Let us suppose that we must send $1 5,000,000 to our citizens 
in England; England must send $5,000,000 to her citizens 
here. This would add another $5,000,000 to the volume of 
bills, $15,000,000 to the volume of remittances. 

Most of our trade with Great Britain is carried on by 
British ships. We must, of course, pay for the service, and 
our payments must be sent to Great Britain. We will place 
the aggregate at $75,000,000. What we carry for Great 



342 INTRODUCTION TO ECONOMICS 

Britain is too little to take into account. So we must add 
$75,000,000 to the volume of remittances without any off- 
setting increase in the volume of bills. 

DUE THE UNITED STATES DUE GREAT BRITAIN 

Exports $500,000,000 $250,000,000 

Interest 5,000,000 75,000,000 

Proceeds of new Repayment of old 

loans 25,000,000 loans 130,000,000 

British travelers' ex- American travelers' 

penses 5,000,000 expenses 15,000,000 

Payment for ocean 

transportation 75,000,000 

$535,000,000 $535,000,000 

Footing up the assumed items of indebtedness, we find 
that the United States can draw bills to the amount of 
$535,000,000, and must make remittances to the amount of 
$535,000,000. Exchange on London will be at par under 
these conditions. 

Of course, it is rarely the case that the payments to be 
made between two countries exactly balance. At one time 
the balance is in favor of one country, at another time in 
favor of the other. When our claims upon Great Britain 
exceed the claims of Great Britain upon us, bills drawn on 
London are below par. When we owe Great Britain more 
than is due us from Great Britain, London exchange is 
above par. 

17. The price of exchange on London depends upon the 
balance of indebtedness between the United States and all 
foreign countries ■, not upon the balance of indebtedness between 
the United States and Great Britain alone. 

For simplicity we assumed that the exchange relations 
between the United States and England were not compli- 
cated by relations with other countries. This assumption 
we must now abandon. The United States buys coffee 
from Brazil. Brazil buys manufactures from England. 



INTERNATIONAL TRADE AND FOREIGN EXCHANGE 343 

England buys wheat from the United States. Now, it is evi- 
dent that Brazilian coffee exporters will be glad to accept 
from American importers bills of exchange drawn on Lon- 
don, as these bills will be in demand among Brazilian im- 
porters of British manufactures. 

If the sums that Americans must remit directly to 
England aggregate $300,000,000, and the sums that Eng- 
land must pay directly to the United States aggregate 
$325,000,000, bills drawn on London may yet be above par. 
For American coffee importers may need, say, $40,000,000 
in bills on London to make payments in Brazil. In this 
case, the remainder of the volume of bills will not be suffi- 
cient to meet the demand for them, and they will go above 
par. 

Even if the Brazilians imported nothing from England, 
bills drawn on London would nevertheless be acceptable to 
them as means of payment for their exports. Brazil must 
import from some country, and that country, in all probabil- 
ity, has payments to make in England, and so will accept 
bills on London in preference to gold. This follows from 
the fact that England has for a century been the financial 
and commercial center of the world. The whole world deals 
with England. Hence bills of exchange drawn on London 
have become a favorite medium of international payments 
throughout the world. If you wish to remit money to a 
missionary in China or to a stockman in Patagonia, you will 
probably do it through exchange on London. Similarly, 
if Chinese or Patagonians have remittances to make to you, 
they will employ exchange on London for the purpose. 

Accordingly, the demand for bills on London is prac- 
tically equal to the whole volume of payments to be made 
by Americans to persons living outside of the United 
States; the supply of bills amounts practically to the 
aggregate payments to be made by such persons to Ameri- 
cans. When we must pay foreigners exactly as much as 



344 INTRODUCTION TO ECONOMICS 

they must pay us, exchange on London is about at par. 
When the balance of payments is in our favor, exchange 
is below par ; when the balance is against us, it is above 
par. Naturally, exchange on London is expressed in terms 
of the British currency — pounds sterling. When ex- 
change is at par, the pound sterling is quoted at $4.86%. 
When exchange is above par, an American who wishes to 
remit a pound sterling to England must pay more than 
$4.86% for it — perhaps $4.88. If the price of a pound 
sterling (exchange) rises above $4.89!, it pays better to 
ship gold. The point at which all advantage in employing 
bills of exchange instead of gold ceases, is known as the 
gold point. If the price of the pound sterling declines to 
$4.83!, it pays holders of bills to send them over to Eng- 
land for collection, with orders that the gold be shipped to 
America. $4.83! is therefore also known as a gold point. 

18. If other items of international payments remain un- 
changed, the pi ice of bills of exchange is lowered by an in- 
crease in exports or a decrease in imports ; it is raised by a 
decrease in exports or an increase in imports. 

If we assume that other items of international payments 
(transmission of capital, interest payments, travelers' ex- 
penses, payments for ocean transportation) remain con- 
stant, it follows that fluctuations in exchange follow 
fluctuations in exports and imports. If we increase our 
exports, imports remaining unchanged, the supply of bills 
increases, and their price tends to fall. If we increase our 
imports, exports remaining the same, the volume of remit- 
tances to be made increases, and exchange rises in price. 

19. Fluctuations in the rate of exchange tend to bring 
about a balance of international payments, through stimulat- 
ing exports and discouraging imports, when exchange is above 
par, and through discouraging exports and stimulating im- 
ports when exchange is below par. 

When bills are above par, it is more than usually prof- 



INTERNATIONAL TRADE AND FOREIGN EXCHANGE 345 

itable to export goods. Let us suppose that in New York 
the price of wheat is ninety-four cents a bushel, while in 
England the price is $1. If it costs five cents a bushel to 
ship wheat from New York to England, the exporter will 
make $100 on a 10,000 bushel shipment, if exchange is at 
par. If exchange is at its maximum above par, the exporter 
will be able to sell his $10,000 bill for $10,060, thus adding 
$60 to his nominal profit of $100. If exchange is at its 
minimum below par, the exporter can get only $9940 for 
his $10,000 bill, thus losing $60 of his nominal profit of 
$100. If a profit of $100 on 10,000 bushels is just suffi- 
cient to induce exporters to ship wheat, no wheat will be 
shipped if exchange is below par. 

When exchange is below par, it is more than usually 
profitable to import goods. Let us suppose that it barely 
pays to import a certain kind of woolen goods when ex- 
change is at par ; that under these conditions the importer 
makes only $100 on a $10,000 shipment. If exchange is 
at its lowest price, the importer can pay for his goods with 
a $10,000 bill costing only $9940. Thus he adds $60 to 
his profits. If exchange is at its highest price, and the im- 
porter must pay $10,060 for a $10,000 bill, $60 is deducted 
from his profit, and the business ceases to be worth while. 

It follows that there is a tendency for an excess of either 
exports or of imports to check itself. If our exports in- 
crease, other things equal, exchange falls, and this dis- 
courages further exports, but encourages imports. If our 
imports increase too rapidly, exchange rises, and this dis- 
courages further imports and encourages exports. 

The fluctuations of the rate of exchange, then, have a 
tendency to create a balance of exports and imports — al- 
lowance made for other items of international indebtedness. 
Exports and imports, in the long run, must increase or de- 
cline together. 

20. If the difference in the general price level between 



346 INTRODUCTION TO ECONOMICS 

two countries is so great that fluctuations in the price of bills 
of exchange cannot bring about a balance of payments, gold 
flows from the one country to the other until the price level 
becomes practically the same for both. 

But suppose that the margin between prices in two coun- 
tries is so wide that it pays to export in spite of a low 
price for exchange, or to import in spite of a high price. 
In the former case, gold must be imported to pay for the 
exports ; in the latter, gold must be exported to pay for the 
imports. Now, we saw in an earlier chapter that an in- 
crease in the supply of money tends to raise prices; a 
reduction of the money supply causes prices to fall. If, 
then, our prices are so low that men find it profitable to 
send an excess of commodities abroad for sale, to be paid 
for in gold, the condition must be transitory. For as the 
gold flows into the country, prices rise, and the exporters' 
gains grow smaller and smaller. If, on the other hand, 
general prices here are so high that it pays importers to 
bring into the country vast amounts of goods, to be paid 
for by exportation of gold, the condition must be equally 
transitory. With the efflux of gold, prices fall, and the 
profits of importers dwindle away. In the end more 
of our commodities become cheap enough to export; 
and so the balance between exports and imports is re- 
stored. 

There are men who hold that the United States should 
endeavor to increase its exports, but systematically dis- 
courage importation. It is obvious that such a policy would 
be futile. If our exports increase, our imports will neces- 
sarily increase also, and vice versa. The fluctuations in the 
price of foreign exchange, and the effects of influx or efflux 
of gold, insure this result. Exports and imports are indis- 
solubly united by natural law ; governments can destroy 
both, but no policy can be successful which aims to foster 
the one while persecuting the other. 



INTERNATIONAL TRADE AND FOREIGN EXCHANGE 347 

21. Summary. 

Trade, both domestic and international, is based upon 
differences in productive powers. The trade between two 
nations may arise from the fact that each possesses exclu- 
sive powers of producing certain commodities; or it may- 
arise from the fact that each is superior to the other in 
some particular branch of production. The differences in 
productive powers upon which international trade is based 
may be due to differences in the character of population, 
differences in traditions of workmanship, differences in 
natural endowment, or differences in supply of capital. 
Of these differences some tend to disappear with lapse of 
time, while others constantly increase in importance. 

A country may profitably import commodities for the 
production of which it possesses natural advantages supe- 
rior to those of the exporting country. This is often the 
case when the marginal productivity of labor and capital, 
and hence money cost of production, is higher in the 
former country than in the latter. 

The trade between two countries is carried on through 
the mechanism of exchange. Gold payments are reduced 
to a mere settlement of balances ; hence it may be said 
that international trade is essentially barter. 

When exports exceed imports, other things equal, ex- 
change falls below par; and this tends to encourage 
importation and discourage exportation. When imports 
exceed exports, exchange rises above par ; and this tends 
to encourage exportation and discourage importation. 
Thus fluctuations in the rate of exchange tend to bring 
about an even balance of exports and imports. If for any 
reason the balance of trade inclines persistently in one 
direction or the other, gold is imported or exported, and 
this, through affecting prices both domestic and foreign, 
ultimately establishes an even balance of international 
exchange. 



CHAPTER XIX 
THE REGULATION OF FOREIGN TRADE 

1. Foreign trade is subjected to governmental regulation 
chiefly under the form of taxation. 

Since early modern times a great part of the energy 
of governments has been expended upon the regulation of 
international trade. The reason for such regulation has 
been twofold. In the first place, there is a deep-rooted 
belief in the people of every nation that the national pros- 
perity may be furthered by restrictions upon trade with 
foreigners. In the second place, such trade has long 
been recognized as a convenient and appropriate source 
of public revenue. 

A century ago the policy of prohibiting the importation 
of some classes of goods, and the exportation of other 
classes, was widely followed. At present this policy has 
practically fallen into disuse. Some of the states of east- 
ern Europe prohibit the exportation of grain when the 
supply appears to be insufficient to keep the people of 
those states from starving. Most countries prohibit the 
importation of certain commodities that are believed to 
menace the health of the consumer. Omitting such ex- 
ceptional cases, however, we may say that the regulation 
of foreign trade is everywhere carried on under the guise 
of taxation. If we wish to prohibit the importation of cot- 
ton from Egypt, we place such high taxes upon imports 
of Egyptian cotton that no one finds it worth while to 
import it. 

Taxes on foreign trade may be levied upon either im- 
ports or exports or upon both. Export taxes are generally 
unpopular, because of the common belief that it is a good 

348 



THE REGULATION OF FOREIGN TRADE 349 

thing to export as many goods as possible. In the United 
States export taxes are prohibited by the Constitution. 
We shall therefore confine our study to taxes on imports. 

2. Import taxes, or " duties" may be levied for the sole 
purpose of raising a revenue, or for the purpose of discour- 
aging the importation of commodities of classes that can 
be produced within a country. Taxes levied for the former 
purpose are called revenue duties ; taxes levied for the latter 
purpose are called protective duties. 

Before the annexation of Porto Rico all the coffee used 
in the United States came from foreign soil. A tax (or 
" duty ") of, say, five cents a pound under the conditions 
would have discouraged importation in only a slight de- 
gree. Most of us would have used as much coffee, even 
at the higher price. A duty of $20 a ton on steel, on the 
other hand, would practically prohibit the importation of 
steel. For our own steel industry can produce steel almost, 
if not quite, as cheaply as that of any foreign country. 
Suppose that we can produce steel at $15 a ton while in 
some foreign country it can be produced at $12. If the 
cost of bringing steel from the foreign country is $2 a ton, 
foreign producers can sell steel here at lower prices than 
our own producers can afford to take. But if foreign steel 
is compelled to pay a duty of $20 a ton, none of it can be 
sold here, unless the American producers combine and 
force steel up to the price of $34 a ton. Such a duty, 
since it "protects" domestic producers against foreign 
competition, is known as a protective duty. 

All duties levied upon imported goods of a character 
that cannot be produced in a country may be classed to- 
gether as pure revenue duties. All duties levied on goods 
of a character that can be produced in a country are pro- 
tective duties. Of course a duty the aim of which is the 
raising of revenue may be incidentally protective. Thus 
if we were to levy a duty on imported coffee, it would 



350 INTRODUCTION TO ECONOMICS 

" protect " the coffee growers of Porto Rico. On the 
other hand, protective duties may incidentally yield a rev- 
enue. In the case employed above, if the duty on foreign 
steel had been $1 instead of $20, foreign steel would 
have continued to be imported, and thus a revenue would 
have been obtained. At the same time the foreigner 
would have been prevented from underselling the Ameri- 
can ; accordingly, the latter would have been " protected." 
Most of our duties are protective, but incidentally yield a 
revenue, as they are not high enough to prevent importa- 
tion altogether. 

The schedule of all duties levied by a country is known 
as the " tariff." A tariff consisting of duties whose main 
object is the raising of a revenue is known as a revenue 
tariff. Such a tariff has long been in force in England. 
A protective tariff consists mainly of duties whose purpose 
is the protection of domestic producers against foreign com- 
petition. Such a tariff has been in force in the United 
States since early in the nineteenth century ; its character 
has been most strongly marked since the Civil War. 

3. Revenue duties on imports are among the most conven- 
ient and popular forms of taxation, partly because the tax- 
payer does not realize how heavy the taxes are, and partly 
because of the common belief that such taxes are borne by the 
foreigners who export the goods. 

Every government needs large funds for the mainte- 
nance of the numerous corps of officials and servants making 
up its civil and military establishments and for the meeting 
of other expenses incurred in the discharge of its various 
functions. These funds must be obtained chiefly through 
taxation. Two methods of raising taxes are open to the 
government. It may send its officials to each man's house, 
and levy upon his person or property. In this case it is 
said to levy direct taxes. The government may, on the 
other hand, impose taxes upon salable commodities as they 



THE REGULATION OF FOREIGN TRADE 351 

are found in the hands of producers or dealers. The latter 
then add the tax, in whole or in great part, to the selling 
price of the commodities taxed. The buyer of the com- 
modities thus bears ultimately all or the greater part of the 
tax. Such taxes are said to be indirect. 

For such obvious and imperative needs of government 
as the construction of highways, the maintenance of courts 
and schools, the average citizen is willing to pay direct taxes, 
although he usually quarrels with the amount imposed upon 
him. The benefits to be derived from a standing army or 
a navy are more remote, and the taxpayer would be far less 
willing to contribute directly to their support than to the 
support of local government institutions. For this reason, 
national governments rely largely upon indirect taxes. The 
average citizen has no very clear idea as to the amount 
of taxes he pays in this way. Whenever you buy a pound 
of imported sugar (and most of our sugar is imported) you 
pay a tax. Whenever you buy English woolens or cottons 
or French silks, you are taxed. If you use tobacco in any 
form, or spirituous malt, or vinous liquors, you pay taxes 
on them. And so with a host of other commodities. How 
great is the aggregate yearly sum that you contribute to 
government in indirect taxes ? You probably have not 
the least idea. But this is certain ; if the entire amount 
were collected from you in cash at one time, you would 
feel that this government of ours is an expensive luxury. 
Statesmen would find much greater difficulty in convinc- 
ing you that we should have the greatest navy afloat, or 
that we should hold ourselves in readiness to enter upon a 
$2,000,000,000 war over a $200 matter. 

Of all indirect taxes, those levied on foreign trade are the 
most convenient. All foreign goods must cross the national 
frontier, where there are always officials and soldiers whose 
services can be employed in preventing goods from being 
secretly carried into the country. A few points through 



352 INTRODUCTION TO ECONOMICS 

which such goods must pass may be designated ; a compara- 
tively small body of officials may be stationed at these points 
to levy and collect the taxes. 

Another reason for the popularity of taxes on imports 
is that many persons believe that such taxes are borne by 
foreigners. If we tax British woolens, French silks, and 
German sugar, are we not compelling the British, French, 
and Germans to help pay the expenses of conducting our 
government ? 

4. Import duties are, as a rule, borne by the consumer, not 
by the importer nor by the producer. 

Let us say that a given grade of woolen goods is pro- 
duced in England at a cost of fifty cents a yard. Under 
the laws of competitive industry, the cloth sells in England 
for very nearly fifty cents. If the cost of bringing it to 
this country is one cent a yard, and there is no tax to 
pay on imports, the cloth will sell here for about fifty-one 
cents. Now if we place a duty of fifty cents a yard on the 
cloth, none of it will be sold here for less than the British 
price plus the cost of transportation plus the tax, or a dollar 
and one cent. The man who buys the goods for use pays 
the tax, in the last instance. And so with most import 
duties. There are exceptional cases in which the whole 
amount of the duty cannot be added to the original price 
of imported goods. In these cases the foreign producer 
may be said to bear part of the tax. As a general rule, 
however, the consumer of the goods pays the tax, although 
he may not be conscious of the fact. 

5. Protective duties are sometimes advocated as a means 
of keeping money at home. 

A revenue tariff needs no defense. A state must have 
revenues, and there is no easier way of collecting them than 
through import duties on commodities that we cannot our- 
selves produce. A protective tariff, on the other hand, re- 
quires more extended consideration. It is designed to foster 



THE REGULATION OF FOREIGN TRADE 



353 



domestic industry at the expense of the business of impor- 
tation. Whether it does this or not is a question of great 
importance. We must see exactly how such a tariff affects, 
not merely isolated branches of industry, but the industry 
of a nation as a whole. 

There is a very primitive view, unfortunately yet far 
from extinction, that it is an evil thing to buy anything from 
foreign producers — even the things that cannot be pro- 
duced in the country at all. Those who hold to this view 
imagine that we must send abroad money to pay for all pur- 
chases, and money, they say, should be kept at home. We 
saw in the last chapter that the medium through which in- 
ternational payments are effected is, in a vast majority of 
cases, bills of exchange. The shipping of gold from country 
to country is reduced, by the mechanism of exchange, to very 
small proportions. Now, the bills of exchange with which 
we pay for our imports are really due bills, representing 
the value of commodities that we export. We saw also that 
if a country for a time imports more than its exports will 
pay for, bills on foreign points rise in price, and this dis- 
courages further importation and encourages further expor- 
tation, until the proper balance between imports and exports 
is again restored. Accordingly, we may cheerfully proceed 
to import as large a volume of commodities as we may desire. 
We shall not thereby run the risk of a serious drain upon 
our money supply ; we shall merely make preparations for 
an unusually large and profitable export trade in the near 
future. 

6. There is no sound reason for discouraging importation 
from countries which do not take commodities in exchange. 

Some men who have advanced beyond the view that 
all importation of commodities is an evil yet cling to the 
belief that importation from countries that do not buy as 
much from us as we buy from them is to be discouraged. 
They argue that such trade must leave a balance which we 



354 INTRODUCTION TO ECONOMICS 

must pay in gold, and this they regard as a net loss. Not 
many years ago one of the administrative departments of 
our national government published a report containing the 
statement that our losses from trade with South America, 
during the last half century, exceeded the cost of the Civil 
War. For we had purchased from those countries billions 
of dollars' worth of commodities in excess of their purchases 
from us. Of course, the facts in the case are, not that we 
have sent billions of dollars in gold to South America, but 
that we have paid the balance in bills on England. Eng- 
land buys more from us than she sells to us, and in her turn, 
sells more to South America than she buys from that region. 
If ever our import trade with South America assumes ab- 
normally large proportions, our export trade with England 
expands in sympathy. It makes not the slightest difference 
whether our foreign trade is three-cornered, as in this case, 
or whether it is carried on directly with one other country. 

7. The argument that the national wealth is necessarily 
reduced when one purchases from abroad commodities that 
can be made at home is fallacious. 

Slightly less shallow is the view that one should not 
buy from foreigners commodities that he can obtain from 
his fellow-citizens, even if the latter demand higher prices 
than foreigners are content to receive. If you wish to buy 
an automobile, it is urged, you should buy one of American 
make, even if you can get as good one of French make a 
little cheaper. By so doing you will increase the prosperity 
of the American automobile industry. You will enable the 
industry to employ more men at higher wages, and to pay 
higher dividends to those who have invested their capital 
in the industry. In order that you and the rest of your 
class may be sure to lend your aid to the American industry, 
the government should place a tax on French automobiles 
imported into the country, which, added to the original price, 
would make them sell at higher prices than those made in 



THE REGULATION OF FOREIGN TRADE 355 

this country. If you then persisted in encouraging French 
industry instead of that of your own country you would 
have to pay dearly for the privilege. 

The ulterior effects of a policy that compels American 
buyers to patronize the home industry are no less happy (so 
runs the familiar argument). The laborers and capitalists, 
being more prosperous, have more to spend on products for 
their own use. The capitalists erect mansions and the 
laborers build cottages, and this creates employment for car- 
penters, masons, and other craftsmen in allied trades. These 
in turn have more money to spend, and increase their pur- 
chases of clothes, provisions, and other articles of use. And 
so the beneficent effects of confining one's purchases of auto- 
mobiles to the American industry are widely distributed 
throughout society. 

In a similar way it is urged that we should buy all our 
sugar from our own producers. There is not much doubt 
that in ten years we could extend our production of sugar 
sufficiently to cover the demand for it, if we would but pay 
a sufficiently high price to tempt labor and capital into the 
industry. Instead of sending $100,000,000 abroad to fruc- 
tify foreign industry, we could keep it at home among our 
own workingmen and capitalists. 

Let us see whether the foregoing argument will bear 
close examination. Assuming that we import $100,000,000 
of sugar in a year, how do we pay for it? Not with gold, 
but with bills of exchange representing the value of com- 
modities that we export. 

Now suppose that we place so high a duty on sugar 
that importation ceases altogether. The immediate effect 
would be a reduction in the demand for foreign bills aggre- 
gating $100,000,000 per annum. Bills would, of course, 
fall below par; men exporting wheat and meat and cotton 
would get less for their products in consequence. The im- 
portation of commodities other than sugar would be stimu- 



356 INTRODUCTION TO ECONOMICS 

lated, as we have seen, by the low price of bills. Exports 
and imports would have to be brought to a balance again, 
and this would come to pass through a shrinkage of exports 
and an increase of imports other than sugar. Perhaps we 
should buy annually $50,000,000 more of these other im- 
ports than we did before, and export $50,000,000 less of 
wheat, meat, and cotton than we formerly exported. The 
producers of sugar are indeed benefited by the elimination 
of foreign competition, but the producers of wheat, cotton, 
etc., are injured by the reduced prices of exports, and the 
producers of other commodities, part of the supply of which 
is imported, are injured by the increase in importation of 
those commodities. Obviously enough, the evil ulterior 
effects of the losses of these two classes of producers cancel 
the beneficent ulterior effects of the gains of the sugar pro- 
ducers. The one effect of the duty that stands out with- 
out any corresponding offset is that we shall pay ten cents 
a pound for sugar instead of five — certainly a result that 
no one can ardently desire. 

8. Protection of all industries is an impossibility. 

But suppose that the government places prohibitive 
duties on all imports. Will not this place all industries 
in a position where they may enjoy higher prices ? And 
in that case, will it not be as easy for us all to pay ten 
cents a pound for sugar as it now is to pay five ? A pro- 
tective system, it is often said, is unjust when it singles 
out a few industries and grants them special favors. But 
it is just if it favors all industries equally. 

An obvious objection is that if this were possible, if 
each industry were enabled to charge prices one hundred 
per cent higher, and each person, accordingly, received 
twice as large an income as he would otherwise have re- 
ceived, no one would secure any real benefit at all. If the 
income of each of us should be doubled, and we had to 
pay twice as much for everything that we buy, we should 



THE REGULATION OF FOREIGN TRADE 357 

be no better off than we are now. But a more serious 
objection is this : no protective policy can raise the prices 
of all commodities. A duty can raise the prices only of 
articles that we are in the habit of importing. Now, if we 
import anything, we must export something to pay for it, 
and the export commodities must ordinarily represent as 
great a volume of values as the import commodities. In 
the case of the United States, the volume of export com- 
modities must be greater than that of import commodities, 
for the former must pay interest on capital that we have 
borrowed and the cost of transporting our trade in foreign 
ships. 

Now, the price of a commodity that we export must be 
lower in this country than in the countries to which it is 
sent. The prices of wheat and cotton in America must be 
less than the prices of the same articles in England, since 
we are constantly exporting them. It is manifestly absurd 
to suppose that by placing duties on wheat and cotton im- 
ported into the United States we can raise the price of 
those commodities. Who would wish to import them into 
the United States ? The duty on any export product is 
utterly ineffective. 

We have seen that restrictions on imports restrict ex- 
ports also. They do this by reducing the amount of 
money that the producer for export receives for his goods. 
An "all around" system of duties, in spite of itself, im- 
poses a positive burden on as large a volume of industry 
as that which enjoys special favors under it. 

9. A plausible but fallacious argument for protection is 
that high wages in America cannot be maintained in free 
competition with low-wage countries. 

Another argument for protective duties runs as follows : 
The American laborer requires a greater measure of the 
necessaries and comforts of life than the laborers of any 
other country. His wages must therefore be higher. It 



358 INTRODUCTION TO ECONOMICS 

follows that American enterprisers, having higher wages 
to pay, are at a disadvantage as compared with their for- 
eign competitors. They must therefore sell their goods at 
higher prices ; and this they would be unable to do if the 
foreign producer could bring his goods here without pay- 
ment of duty. From this point of view the tariff is re- 
garded as the bulwark of the American standard of living. 
This argument can no more bear analysis than the pre- 
ceding ones. All the export industries are able to pay the 
American scale of wages, and yet undersell their foreign 
competitors on foreign soil. These industries are ham- 
pered, not aided, by the protective system. Apart from 
the injury inflicted upon them by an unfavorable rate of 
exchange, these industries are rendered less profitable by 
the fact that many of their expenses are increased by the 
tariff. Wheat and cotton growers are compelled to pay 
higher prices for agricultural implements, lumber, fertil- 
izers, and other supplies because of the protective duties. 
The duties on iron and steel increase the costs of railway 
building and are reflected in higher freight rates, which 
represent a deduction from the net gains of the producers 
of the commodities that are carried to the ports by rail. 
If restrictions on imports reduce the amount of freight 
carried to this country from Europe, many ships are com- 
pelled to cross the ocean in ballast to carry away our 
exports; and this means that the exports have to pay 
ocean freights covering the costs of a return voyage, in- 
stead of a single passage of the ocean. Now, when we 
consider that in spite of all these disadvantages the export 
industries can retain the home market and invade foreign 
ones, we see clearly that a protective tariff is not needed 
to maintain the American rate of pay in all industry, 
although it may be necessary to maintain that rate in 
special industries — industries in which our advantages 
for production are less telling than they are in those in- 



THE REGULATION OF FOREIGN TRADE 359 

dustries that have succeeded in conquering a place for 
themselves in foreign markets. 

10. A policy which draws labor from the fields that are 
of greater natural productiveness to fields of lower natural 
productiveness tends to reduce wages. 

In order to gain a clear view of the relation of a protec- 
tive duty to the rate of wages we must return to funda- 
mental principles. In any country, as was shown in earlier 
chapters, wages are determined by the marginal produc- 
tivity of labor. We will represent the various opportuni- 
ties for employment that a country like the United States 
affords by the symbols A, B, C, and D. A may stand for 
a group of industries in which we have exceptional advan- 
tages over foreign countries. B stands for a group of in- 
dustries in which our advantages are less, C one in which 
they are still less, and D the group of industries in which 
they are least of all. When our population is so small that 
all our labor can be engaged in the group represented by A, 
wages will be at their maximum. When our population 
increases so that some of the labor will have to be set at 
work in group B, the wages of all labor must decline to 
the level of productivity in that group. We will suppose 
that population has increased up to a point where the op- 
portunities represented by A and B are fairly well manned, 
and wages are determined by the productivity of labor in B. 

With wages thus determined, it is clear that no employer, 
without governmental aid, can afford to hire labor to ex- 
ploit the opportunities represented by C and D. This 
would necessitate paying labor in C and D as much as it 
produces in B, and that, by hypothesis, is more than it 
produces in C and D. 

Now let us suppose that a political party is in power 
which holds the belief that we should produce everything 
that we consume — that is, that the opportunities repre- 
sented by C and D should be exploited as well as those rep- 



360 INTRODUCTION TO ECONOMICS 

resented by A and B. Labor must be drawn away from 
A and B and set at work in C and D. This involves the 
necessity of compensating enterprisers in some way for 
the disadvantages under which they will operate in C and 
D. Either wages must be reduced in A and B, or some 
form of subsidy must be granted to C and D. 

The commodities that the industries composing C and D 
will produce have been hitherto, we assume, obtained from 
abroad through exchange for commodities produced by A 
and B. The government now renders this difficult by 
placing high duties on the former class of commodities. 
This means that producers in the groups A and B — 
both employers and workmen — must pay higher prices 
for what they buy. They do not receive higher prices for 
what they sell ; in fact, they receive lower prices, as this, 
we have seen, is the effect of protective duties on export 
industries. It appears, then, that part of the disadvantage 
of producers in C and D is removed by reducing wages 
(estimated in purchasing power) in A and B. 

After the duty has gone into effect and the prices of 
commodities that can be produced by C and D have risen 
sufficiently, enterprisers will be able to hire labor at the 
wages prevailing in A and B, and establish industries in 
C and D. So far as the remaining laborers in A and B buy 
the products of C and D, the difference between the price 
which they pay for those products and the price that they 
would pay if they were permitted to import those products 
duty-free is a tax paid not to the government, but to the 
producers in C and D, to enable the latter to remain in busi- 
ness. It is an uncompensated deduction from the natural 
earnings of the laborers in A and B. Their wages have 
been reduced; nor are the workers in C and D paid as 
much, estimated in purchasing power, as they would have 
received if they had been allowed to remain in A and B 
under the earlier conditions. The net effect of the impo- 



THE REGULATION OF FOREIGN TRADE 361 

sition of the duty has been to saddle the self-supporting 
industries, A and B, with the support of the pauper indus- 
tries, C and D. Yet the inventors of this policy have the 
effrontery to tell laborers in A and B that this policy is the 
bulwark of their high rate of wages ! 

The principles involved in the illustration may be stated 
in the following general terms : Wages in any country will 
be at the highest point when all the labor of that country 
is concentrated in the industries in which its relative ad- 
vantages over other countries are greatest. If there are 
no protective duties whatsoever, employers will, as a rule, 
seek out the industries in which their country has the 
greatest relative advantages. Protective duties enable 
other industries to exist, but only through taxing the more 
productive industries for their support. Protection as a 
permanent policy means a slight reduction of money 
wages, and a greater reduction of wages estimated in pur- 
chasing power. Instead of a bulwark of the standard of 
living, protection is a serious menace to it. 

11. The strength of the protectionist policy consists largely 
in the fact that the good effects of the policy are more easily 
perceived than the evil effects. 

The arguments for protection that have been discussed 
are all manifestly fallacious. They are not therefore to be 
despised, since to hosts of men they appear to be absolutely 
irrefutable. And this, as a great French economist was 
wont to say, is because the average man is unable to weigh 
the unseen effects of an economic policy against the effects 
that are seen. If we place a high duty on imported fab- 
rics, the resultant high prices enable a new industry, em- 
ploying thousands of workmen, to be established. This is 
the effect that is seen, and considered in itself, is wholly 
good. Every purchaser of the fabrics throughout the land 
is compelled to pay higher prices for them ; but this effect 
is only dimly seen, if at all. In itself, it is wholly evil. 



362 INTRODUCTION TO ECONOMICS 

Since part of what the new industry receives in this way 
from the public goes to compensate that industry for the 
natural disadvantages under which it labors, it follows that 
the aggregate net gain to the industry is less than the ag- 
gregate net loss to the public. Again, the national pro- 
duction of wealth is increased by the amount that the new 
industry adds, and this effect of the duty is one that is seen. 
The national production is reduced by the amount that the 
labor and capital diverted to the new industry would have 
produced elsewhere ; this effect is not seen. Yet the re- 
duction in national production that the duty entails is 
greater than the increase due to it, since labor and capital 
are diverted from the branches of production enjoying 
greater natural advantages to branches enjoying lesser 
advantages — a fact proved by the very need for a duty. 

12. Protection increases the productiveness of labor and 
capital if it drives labor and capital out of the less produc- 
tive into the more productive fields. 

In the foregoing discussion the assumption has been 
made that when left to themselves enterprisers will seek 
out the industries enjoying the greatest natural advantages. 
On this assumption, all that government can do is to force 
industry into the less productive fields — a policy that can 
result only in reducing the national production. 

Now, while the assumption is ordinarily defensible, it is 
not universally valid. Enterprisers do not always know 
what fields offer the highest rewards. Furthermore, even 
if an enterpriser suspects that a given field, hitherto unex- 
ploited, would offer rich returns, conservatism may deter 
him from abandoning a field in which he is already gaining 
profits for a field in which he may gain larger profits, but 
in which he may also incur losses. 

The men who govern a nation may be more far-sighted 
and more progressive than the business men of the same 
nation. The former class of men may become convinced 



THE REGULATION OF FOREIGN TRADE 363 

that certain fields of production will be profitable long be- 
fore the latter class will venture into those fields. The 
government, by placing duties upon the products that those 
fields might yield, makes success a certainty. Once the 
new industries are established, the duties can be removed 
without destroying them. The industry of the nation is 
enriched by the addition of fields of employment that are 
as good or better than those already under exploitation. 

It must, of course, be borne in mind that this case is a 
rare one. It is not often that the statesman knows more 
about business than the body of business men themselves. 
Where, however, the government is manned by officials of a 
race intellectually superior to that of the governed, the 
national industry may be furthered in the way described. 

13. Protection may enable an industry of more than nor- 
mal productiveness to surmount initial obstacles to success. 

Even when there exists no superiority of foresight on 
the part of those who make up the government, a govern- 
ment may often succeed in diverting industry from fields in 
which the natural advantages are less to fields in which 
they are greater. The United States has always pos- 
sessed special natural advantages for the production of 
iron and steel. What it lacked, in its early period, was 
training in the art of working metals. The enterpriser 
was unacquainted with the best processes, and he had to 
use labor that had not acquired the skill and the traditions 
necessary for efficient production. 

Now, the only way to acquire an art is to practice it. 
We had to make iron for a long time before we could be- 
come adepts in the art. A generation might have sufficed 
for establishing the industry in a particular locality ; but 
what enterpriser would have undertaken to produce at a 
loss through a generation in order that some other enter- 
priser might ultimately conduct the business with a profit ? 
Obviously, the case emanded governmental aid ; and the 



364 INTRODUCTION TO ECONOMICS 

government did indeed come to the aid of the industry, 
through the imposition of duties on imported iron and iron 
wares. 

After a reasonable period of time the iron industry may 
become well established in a given locality, but if the pro- 
duction of iron in other localities promises ultimate success, 
the duties, it is urged, should be continued for the benefit 
of these localities. At a time when the first center of the 
industry is in a position to bid defiance to foreign competi- 
tion, other centers are still in extreme need of protection. 

14. When an industry is well established within a country, 
protection becomes tmnecessary. 

To-day our iron and steel industries are highly developed. 
There is excellent reason for believing that in many sec- 
tions of the country these industries could get on very well 
without the protection they continue to receive. In other 
parts of the country the industry may still be in need of 
protection. Now, is it expedient to continue protection as 
long as any part of the industry needs it ? To do so is to 
enable those parts that are already able to stand without 
aid to levy upon the rest of the industry of the country. 

After an industry has been well established within a 
country, it migrates without great difficulty to other parts 
of the same country, if natural conditions warrant. When 
the iron industry has been established in Pennsylvania, it 
readily migrates to Alabama or Colorado, if natural condi- 
tions are as good or better than they are in Pennsylvania. 
Processes that are in use in Pennsylvania can be trans- 
ferred without cost to the other regions ; a body of workers 
can be induced, without great difficulty, to migrate with the 
industry. There is accordingly far less reason for giving 
governmental aid to the newer centers than there was for 
giving it to the original one. Accordingly, we may say 
that it may be advantageous to protect an industry until it 
is well established within the national domain ; if it is of a 



THE REGULATION OF FOREIGN TRADE 365 

character that fits it for existence there, it will extend itself 
to other regions even if protection is withdrawn. 

15. In practice it is difficult to determine when protection 
should be withdrawn from an industry. 

When an industry has become firmly established, fur- 
ther protection is inexpedient and unjust, as it enables the 
industry to levy upon other industries that are self-sup- 
porting a tribute that it does not need. Here a practical 
difficulty arises. How can we determine just when an indus- 
try has passed through the period of infancy, and therefore 
should be left to shift for itself ? We cannot find out from 
those who are engaged in the industry, since they are natu- 
rally desirous of a continuance of public aid, even though 
they do not need it; and those who are not engaged in the 
industry cannot tell. 

At the annual banquets of the various manufacturers' 
associations, the boast is frequently made that we can manu- 
facture more cheaply than any other nation on earth. But 
if Congress proposes to reduce duties, the same men soberly 
declare that our industries will be ruined if this is done. 
And shall Congress, in its search for truth to enlighten it, 
appeal from the manufacturers sober to the manufacturers 
off their guard and intoxicated with success ? The fact is, 
it is almost impossible for a government to determine just 
when a protective duty can be removed. As a result every 
nation retains many such duties long after they have lost all 
efficacy for doing anything but harm. Accordingly, there is 
good reason for the view that reckless experimentation in 
the establishment of new industries is to be avoided. 

16. The establishment of industries that will never be able 
to maintain themselves without protection should be avoided. 

A stronger reason for cautious action lies in the fact 
that an industry established by the aid of a protective duty 
may never develop sufficiently to maintain itself without 
governmental aid. The natural conditions upon which it is 



$66 INTRODUCTION TO ECONOMICS 

based may be so unfavorable, relatively to the conditions 
in other countries, that the industry, if established here, will 
be destined to remain forever a burden upon the public — a 
pauper industry. Let us suppose that in a given branch of 
industry a commodity can be produced here at a cost of 
$i, while it can be obtained from abroad for fifty cents. 
Without government aid, no enterpriser can afford to under- 
take its production. Now, let us assume that a statesman, 
eager to see the United States producing every possible 
kind of goods, succeeds in placing a duty of fifty cents on 
the imported article. The price to consumers must then 
rise to $i, a price sufficient to induce American enterprisers 
to produce the goods. 

After all the initial difficulties, such as training a force 
of men, establishing market conditions, etc., have been over- 
come, the cost of producing the article may fall to seventy- 
five cents, and remain there. This is the natural American 
cost of it. If the duty is removed, the foreign article will 
again be sold for fifty cents. The men who have put their 
capitals into the industry will have to close down their plants 
and discharge their workmen. The buildings and machinery 
used in the industry will probably be worth almost nothing 
for any other purpose. The skill acquired by the workmen, 
at great cost of time, perhaps, will be equally worthless. 
The removal of the duty, therefore, involves the ruthless 
destruction of means of wealth production, through no fault 
of the possessors of such means. 

The question naturally arises, is it right to call an in- 
dustry into existence by governmental action, and later aban- 
don it to the mercies of foreign competition? There can 
be but one answer : It is not right. The government did 
wrong in calling into existence an industry that would never 
be able to survive unaided. It does wrong again when it 
abandons its ill-begotten offspring to die of starvation. If, 
however, the industry is not abandoned, it is a perpetual ex- 



THE REGULATION OF FOREIGN TRADE 367 

pense to the self-supporting industries of the country. A 
human pauper dies in the end, but a pauper industry may 
live on forever. 

17. Protection may serve a useful purpose in encouraging 
the development of industries that make no drain upon the 
natural resources of a country, and retarding the develop- 
ment of industries that destroy such resources. 

A protective tariff may sometimes be defended on the 
ground that it preserves the natural resources of a country 
against wasteful exploitation. If the government does 
not restrict international trade, we may, as a rule, assume 
that enterprisers will seek out the fields in which a given 
quantity of labor and capital will produce the largest 
amount of value, or the fields in which our advantages 
over foreign countries are greatest. Let us suppose that 
one of those fields is the growing of wheat. In most parts 
of the United States wheat culture represents a heavy 
drain upon the fertility of the soil. Land devoted to con- 
stant wheat cropping becomes almost exhausted in a gen- 
eration. Accordingly, when one sells a bushel of wheat, 
he sells not only the product of his labor and capital, but 
a part of the natural heritage of his country. But why 
should he care ? After his field is worn out, his years will 
probably be few. The next generation may be left to 
repair the wastes of this generation. 

Let us suppose that coal and iron mining and the pro- 
duction of petroleum are other industries in which we have 
great natural advantages. Enterprisers, if left to them- 
selves, would employ vast amounts of labor and capital in 
exploiting these natural resources. Every year we should 
send away from our country these commodities, represent- 
ing not merely the annual product of our labor and capi- 
tal, but also a part of our irreplaceable natural wealth. In 
a few generations we should be, as a nation, impoverished. 

We have seen that protection places a burden upon the 



368 INTRODUCTION TO ECONOMICS 

industries in which we have, for the present, great natural 
advantages, in order to build up industries in which our 
natural advantages are less. If the industries that are nat- 
urally most productive are of the kind that waste the natu- 
ral wealth of the country, it is a statesman's proper policy 
to impose upon them such burdens, and so reduce the 
extent to which they are carried on, in favor of industries 
which involve no waste of resources, even though the an- 
nual production of wealth is thereby diminished for a time. 

The same argument, of course, condemns protection 
under other circumstances. According to conservative 
official estimates, we are using up, each year, four times 
as much lumber as we are growing. The rising price 
of lumber stimulates the activity of the woodsman to 
greater and greater remorselessness. Our mountains are 
denuded, and the waters, formerly held back by the forest 
covering and allowed to feed the rivers with regular flow, 
now sweep down the slopes in devastating flood. Obvi- 
ously, we should endeavor to stimulate importation of lum- 
ber ; if necessary, we should give a bounty on imports, 
that the price of lumber might be reduced and our few 
remaining forests saved. But the destroyers of our natu- 
ral heritage demand protection in their pernicious pursuit, 
and we accord it to them. 

18. Protection may serve the purpose of encouraging the 
development of industries that are favorable to the health of 
the laborer. 

If extractive industries, prosecuted too relentlessly, waste 
the natural wealth of a country, manufacturing industries, 
prosecuted in the same way, waste its men. The popula- 
tion of a manufacturing center does not usually compare 
favorably, in health and vigor, with the population of rural 
districts. Indeed, it is doubtful whether an exclusively 
urban, manufacturing population can in the long run 
escape physical degeneration. It might therefore be good 



THE REGULATION OF FOREIGN TRADE 369 

policy in a country so largely devoted to manufactures as 
England to impose protective duties on imported agricul- 
tural products, with a view to increasing the proportion of 
the population employed upon the land. This would in- 
deed burden the manufacturing population ; it would for 
many years reduce the product of the national industry. 
But in view of the ultimate effect upon the character of 
the population, this policy might be a good one from the 
point of view of the statesman, who must consider not 
merely the prosperity of this year and next, but also that 
of the remotest generations. 

There are industries that in the end destroy the health 
of those who are engaged in them. A frequently cited 
case is a certain branch of the match industry, which con- 
demns its workers to early disability or death. Yet in 
many countries that industry asks for protection and gets 
it. Protection and encouragement to an industry that lit- 
erally devours one's fellow-countrymen ! 

19. A country should be able to provide itself with means 
for producing commodities essential to the successful conduct 
of a war ; and in many cases can make such provision most 
conveniently through protection. 

A protective duty is defensible when it serves to main- 
tain facilities for the production of articles of national neces- 
sity, the supply of which might be cut off by war. War 
vessels can be built in Great Britain at far less cost than in 
the United States. In time of peace we should make im- 
portant savings by having our war vessels built in Great 
Britain. If we were engaged in a war, however, we could not 
have warships built in Great Britain, whether that country 
were hostile or neutral. Yet it is precisely at such a time that 
we should most need to increase our navy. Prudence there- 
fore demands that we should provide ourselves, in time of 
peace, with establishments capable of turning out warships ; 
and this involves giving them work to do. 



370 INTRODUCTION TO ECONOMICS 

It is a moot question whether the creation of facilities 
for constructing merchant ships stands on the same foot- 
ing. In former times, certainly, a merchant fleet was an 
indispensable auxiliary to a fighting fleet. The former fur- 
nished trained seamen, and many merchant vessels were 
capable of speedy transformation into warships. Modern 
methods of construction, however, have widely differentiated 
between merchant ships and ships of war. The former can- 
not be fitted out in such a way as to enable them to perform 
efficient service in line of battle. The crews of merchant 
ships are not such satisfactory material for a naval force as 
was formerly the case. Whether the national defense re- 
quires the development of a sea-going merchant fleet or not 
is a question for disinterested experts to determine. If it 
does, protection to the American merchant marine is defens- 
ible, despite the cost that it inevitably entails. 

Many industries that are not designed directly for the 
supply of articles of military necessity may be placed in the 
same class. In order that we may be able to construct ships 
and produce guns and other instruments of war, we must 
have men who are trained in metal working; and if there is 
no other way of maintaining such a force of workmen, we 
should create and maintain an iron and steel industry 
through protective duties. It is, however, to be borne in 
mind that the maintenance of an industry large enough to 
cover all the demand for iron and steel in time of peace can- 
not be urged on grounds of national defense. 

20. A policy which aims to make a country completely in- 
dependent of the products of other countries is more likely 
to create weakness than strength in war. 

There are some writers who extend the principle in- 
volved to an unwarranted extreme. They would have every 
nation produce practically every article that it consumes, 
in order that in time of war there might not be the least in- 
terruption of supplies. These persons exaggerate the de- 



THE REGULATION OF FOREIGN TRADE 371 

pendence of one country upon any other country against 
which it may at some time wage war. England, every one 
knows, does not produce enough grain to feed her popula- 
tion. Suppose that England found herself at war with the 
United States. That would indeed cut off American sup- 
plies of wheat and meat and cotton. But there are many 
other countries that would be glad to provision England at 
the rates she can afford to pay ; and as for cotton, the Eng- 
lish buyers would not be a whit worse off than the American 
sellers, cut off from their natural market. 

But suppose that a coalition of all the powers succeeded 
in destroying the British fleet, and in cutting off supplies 
from every source. Would not Great Britain be brought 
face to face with famine ? Certainly. But a coalition strong 
enough to do this would be strong enough to invade and sub- 
jugate Great Britain, even if that country were absolutely 
self-sufficing. Furthermore, any one who knows anything 
of the history of coalitions knows that none will ever be 
formed for the purpose of bringing the British nation to 
extinction. 

The strength of a nation in time of war does not de- 
pend upon its ability to produce everything that its inhabit- 
ants consume. Rather, it depends upon the valor and num- 
ber of its men, and upon its general wealth. Other things 
equal, a rich nation will overcome a poor one in war. Great 
Britain is formidable because she is rich. Now, the endeavor 
to make a nation absolutely self-sufficing would end in mak- 
ing it much poorer than it would be if it used its resources 
in a more economical way. If we were to endeavor to raise 
coffee and tea, lest an impossible coalition of all the world 
might inflict upon us the hardships of dry breakfasts, we 
should waste so much of our energies in the attempt that we 
should be weakened in the event of an ordinary war, in 
which we may any day become involved. 

21. Duties imposed by way of retaliation are seldom ad- 
vantageous to the country that imposes them. 



372 INTRODUCTION TO ECONOMICS 

One further possible justification of duties designed to 
discourage importation requires examination. Other coun- 
tries impose duties upon American products crossing their 
borders. Therefore, it is said, we should impose import 
duties on the products of such countries, by way of retali- 
ation. Let us see whether this position is tenable. 

If Germany places a high duty on American meats, the 
persons who are injured most seriously are the German 
consumers of meat. The German producer of meat gains 
an advantage, but this, under ordinary circumstances, is 
not commensurate with the loss to the German consumer. 
The world demand for American meat is somewhat reduced, 
and this reduces the price of it slightly. A small injury, 
therefore, is inflicted upon the American producer of meat. 

Now let us suppose that in retaliation we levy extraor- 
dinary duties on German sugar. The chief sufferer will 
be the American consumer of sugar. The American pro- 
ducer will gain, but not commensurately. The world de- 
mand for German sugar will be reduced, and this will 
slightly reduce the price of it. Thus, in order to punish 
Germany for inflicting a large loss on German consumers 
and a small one on American producers, we inflict a large 
loss on American consumers and a small one on German 
producers. 

But retaliation is war, and in war the petty rules of logi- 
cal conduct are not to be observed. The important ques- 
tion is this : does the policy of retaliation effect its purpose ? 
Will we compel Germany to remove the obnoxious duty ? 
In all probability, no. After the duty on meat has been in 
force for some time, German producers will increase their 
facilities for producing that article. To remove the duty 
and expose to the mercies of foreign competition the men 
who had invested their capital in good faith would be a 
policy as unjust as it would be unpopular. Similarly, 
American enterprisers would extend their facilities for pro- 



THE REGULATION OF FOREIGN TRADE 373 

during sugar, and this would give them an equitable claim 
to a continuance of the duty. The only result of retalia- 
tion is the institution of permanent protection. If per- 
manent protection is desirable, it should be undertaken 
without reference to the way in which a foreign govern- 
ment conducts its own affairs. If it is undesirable, it 
should not be undertaken at all. 

22. Summary. 

In conclusion we may say that protective duties may be 
defensible (1) when they make possible the introduction of 
an industry which in a reasonable time will compare favor- 
ably in productivity with industries that are already self- 
supporting ; (2) when they preserve the natural resources 
of a country from wasteful exploitation ; (3) when they 
preserve the vigor and progressiveness of the population 
through the maintenance of a just balance between manu- 
facturing and agriculture, city and country ; and (4) when 
they make possible the maintenance of industries that add 
materially to a country's strength in time of war. In any 
case such duties are a burden upon the national wealth, at 
the time when they are instituted, and often for an indefi- 
nite time thereafter, and whether the benefit to be gained 
is a due compensation for the burdens involved is a ques- 
tion demanding in each case careful consideration. Duties 
that are designed to raise wages or to increase the national 
wealth by the introduction of industries in the prosecution 
of which we have no special advantages, are founded in a 
delusion. They are rendered possible only by the fact 
that the ordinary mind does not weigh their unseen disad- 
vantages against their advantages patent to view. 



CHAPTER XX 

THE RELATIONS OF GOVERNMENT TO THE ECONOMIC 
ORGANIZATION 

1. The economic and the legal systems of a country are, in 
a measure, interdependent. 

The economic world with the study of which we have 
been engaged is a world of free private enterprise. Its 
motive forces are the acts of individuals, each seeking to 
further his own material interests. When such individuals 
buy or sell material possessions or personal services, they 
take little thought of the interests of society as a whole, and 
are little concerned with the wishes or the will of society. 
Yet the will of society plays a part in all these transactions, 
for they are shaped with tacit reference to the law. The 
individual is free to pursue his own interests only within the 
limits set by the positive law of the land. 

If we attempt to contrast the present economic state with 
the state that would probably exist were there no political 
organization of society, we shall realize that the will of 
society, as expressed in the acts of government (employ- 
ing the term in its broadest sense) , has played an exceed- 
ingly important part in economic evolution. Without a gov- 
ernment strong enough to assure to each man the permanent 
possession of material goods acquired in ways recognized as 
legitimate, humanity could hardly have developed beyond 
the hunting, or at any rate the pastoral, stage. Without a 
government able to enforce contracts for the future delivery 
of goods and services, humanity could not have passed be- 
yond the stage in which the small artisan produced goods, 
on his own account, for a narrow local market. Progress 
in the art of government has been a necessary condition of 

374 



RELATIONS OF THE GOVERNMENT 375 

substantial economic progress. On the other hand, it was 
in large measure progress in economic life that necessitated 
progress in government. Some of the most serious practical 
problems of to-day have their origin in the fact that political 
evolution has not kept pace with economic. Our political 
machinery, which developed under simpler economic condi- 
tions, appears in many instances incapable of maintaining 
justice under the complex conditions of the present time. 

2. The basis of modem economic policy is free private 
enterprise, or laisser-faire. 

A government may limit its economic activities to the 
defense of private property and the maintenance of the 
obligation of contracts. It may assume the function of 
determining the conditions under which economic transac- 
tions are carried on, and may even interfere in their terms. 
It may engage directly in the production of goods and ser- 
vices. In the first case the government is said to pursue a 
" let alone " or laisser-faire policy ; in the second case, a 
regulative or "paternalistic" policy; in the third, a social- 
istic policy. In general, the basis of modern economic 
policy is laisser-faire. It is true that the regulation of an 
industry by government is a not infrequent phenomenon, 
and the direct participation by government in the produc- 
tion of commodities and services is not by any means 
unknown. Nevertheless, an overwhelming majority of 
modern economic transactions are carried on by private 
individuals, subject to no direct interference on the part of 
the government. 

The question may arise whether the existence of protec- 
tive tariffs in most of the countries of the world does not 
make it necessary to qualify the statement that laisser-faire 
is the basis of modern economic policy. In effect, the 
United States government prevents us from buying Eng- 
lish steel, and compels us to buy steel of American manu- 
facture. Yet the method by which it does this does not 



376 INTRODUCTION TO ECONOMICS 

resemble the method of governmental regulation, to be 
discussed below. The government imposes the condition 
that every ton of steel crossing our borders shall pay a 
certain tax. This condition met, the steel becomes an arti- 
cle to be dealt in freely. In buying or selling it men 
consult only their self-interest. The imposition of the 
duty creates a steel industry in this country; but the 
method by which this is done is very different from 
the method of governmental production. Prices are en- 
hanced ; and this leads individuals, in the pursuit of their 
private interests, to engage in steel production. The gov- 
ernment, as it were, creates a favorable soil in which free 
enterprise may flourish. We may, therefore, say that the 
existence of customs barriers does not render necessary a 
qualification of the statement that the economic policy of 
modern governments is based upon the principle of laisser- 
faire, or free enterprise. 

3. The question whether the system of free private enter- 
prise is conducive to the greatest human welfare demands 
consideration. 

The system of free enterprise has been at once the sub- 
ject of extravagant praise and of savage criticism. Some 
writers attribute to it all the progress in civilization that the 
last centuries have witnessed. To these writers every en- 
croachment by government upon the domain now occupied 
by private enterprise is fraught with grave dangers. 
Other writers regard the system as wholly corrupt, and 
hope to see it replaced either by a system under which all 
economic activities are minutely regulated by government, 
or by one in which the government itself carries on all pro- 
duction of wealth in behalf of society as a whole. 

An exhaustive treatment of these opposing views would 
carry us far beyond the scope of the present work. We 
may, however, consider briefly whether, on the whole, the 
system of free enterprise meets the tests of justice and of 



RELATIONS OF THE GOVERNMENT 377 

social expediency. If it does this in the main, there may- 
yet be a distinguishable field in which individual enterprise 
should be subjected to governmental regulation, and yet 
another field in which the government should participate 
in the production of wealth. A part of our task must be 
to find the boundaries of the respective fields, if such boun- 
daries really exist. 

4. From the point of view of production the system of 
free private enterprise has proved highly effective. 

There can be no question that the productive power of 
man has been immensely increased in the two or three 
centuries in which enterprise has been accorded a fair 
measure of freedom by government. Improvements in 
methods of production and the formation of vast accumu- 
lations of capital have reduced greatly the amount of toil 
necessary for the maintenance of human life. The amount 
of commodities placed at the disposal of the average man 
has been vastly increased. Relief from toil and command 
over commodities are not tantamount to well-being; but 
they serve at least as a basis of well-being. 

It would be unjustifiable to ascribe the entire sum of 
progress in production to freedom of enterprise. Many 
other causes have contributed to this progress ; but there 
is no doubt that many inventions have been made with a 
view to the profits that might flow from them; and the 
wide introduction of improved processes of production has 
been largely the result of the pursuit of profit. 

5. From the point of view of the distribution of wealth it 
is not so clear that the system of free private enterprise has 
resulted in unmixed good. 

One of the patent results of the system of free enterprise 
has been the formation of classes differing greatly in their 
command over wealth. Inequalities in fortune were prob- 
ably never greater than they are to-day. It cannot be 
said that the poor are poorer than they were in earlier 



378 INTRODUCTION TO ECONOMICS 

stages of the world's history, but it is quite possible that 
the wretchedness of the poor in our great and wealthy 
cities is greater than was the case in earlier times. The 
questions therefore naturally arise whether or not the 
existing system is just in its distribution of wealth, and 
whether a system more conducive to human welfare could 
not be devised. These questions involve so many consid- 
erations that it is doubtful whether any human mind can 
answer them conclusively. 

6. In the apportionment of profits among enterprisers •, a 
measure of justice and social expediency is discernible. 

We may first inquire whether the existing system tends 
toward justice from the point of view of those who direct 
production, the class of enterprisers. Under competition 
any enterpriser may engage in any branch of production, 
and create and sell wares to his best advantage. Any 
enterpriser may make a calculation of costs and prices in 
the various branches of production. If prices are high in 
any one field, relatively to cost, new enterprisers press into 
the field ; the supply of the commodity is increased, and its 
price falls. It follows that there is a tendency for the 
various classes of goods to exchange, one for the other, in 
proportions corresponding with their respective costs of 
production. When this point has been reached, justice, as 
between different enterprisers, has been established. 

At any given time, it is true, some enterprisers receive 
greater rewards, in proportion to their outlays, than others. 
But if competition is free, this can happen only when not 
enough of one commodity is produced and too much of an- 
other. The high rewards given to enterprisers in the one 
field are an inducement to the expansion of production in 
that field ; the low rewards in another field give warning 
that less of the product of that field is wanted by society. 
The unequal treatment of enterprisers is the means by 
which society compels them to direct their forces in such a 



RELATIONS OF THE GOVERNMENT 379 

way as best to meet society's needs. The inequalities are 
salutary in their effects ; when there is no longer an im- 
proper distribution of productive energies, they cease to 
exist. 

7. There is a tendency toward fairness in the distribution 
of rewards among the different classes of workmen and 
among capitalists. 

In a similar way, the system of free enterprise tends to 
establish justice as between different classes of workmen. 
If in any industry wages are above the average, due allow- 
ance made for relative agreeableness and safety of employ- 
ment, labor tends to flow into that industry from industries 
in which wages are below the average. Wages then fall 
in the former industry and rise in the latter. The initial 
inequalities in wages signified that there was too much 
labor in some fields, too little in the others, and the very 
fact of inequalities of reward helped to correct this condition. 
Justice is done as soon as social expediency permits. Simi- 
larly, there is a tendency toward equality of rewards for 
invested capital. 

8. The question of justice, as between the different eco- 
nomic class es, admits of no definite answer. The existing 
distribution among such classes may be justified, perhaps, 
on grounds of social expediency. 

Can it be said that the system of free enterprise insures 
justice in the relations of enterprisers, capitalists, and labor- 
ers with one another ? There is no way of weighing the 
sacrifices undergone by those who direct industry against 
the sacrifices of those who furnish capital and of those 
who labor. We can, however, weigh the services to so- 
ciety of the respective classes ; and we can say that there 
is a tendency for rewards to proportion themselves to ser- 
vices. This is not equivalent to saying that the distribu- 
tion thus based on services is just. For how came the 
millionaire into a position where he can serve, as it were, 



380 INTRODUCTION TO ECONOMICS 

by proxy — his millions bringing him great rewards, while 
the laborer, serving in person, receives but an insignifi- 
cant return ? From the point of view of social expediency, 
however, it seems more plausible that a distribution based 
on service is satisfactory. Assuring to the capitalist the 
fruits of his capital encourages the formation of new and 
greater capitals, and these are powerful instruments for 
increasing the social production and hence for improving 
the economic condition of all. 

9. When the parties to a contract are unequal in skill 
and strength, injustice is likely to result. 

An economic system based upon free contract will be 
just and socially expedient only when the parties to each 
contract stand on a footing of substantial equality. In the 
first place, the buyer must know the properties of the 
goods offered to him as well as the seller knows them ; 
the laborer must know the risks and inconveniences attach- 
ing to a given employment as well as the employer knows 
them. When an unscrupulous horse dealer foists upon an 
unsuspecting buyer an animal with a hereditary taint of 
character or defect of body, the social welfare is in some 
degree reduced. The seller receives wealth, not for his 
services, but for his rascality; the buyer parts with his 
money, not for utilities, but for " experience." If all trade 
were of this nature, as it was among the ancient Greeks, 
we should, like the ancient Greeks, regard trade and 
piracy as twin callings. 

10. Free enterprise results in approximate justice only 
under competition. 

In the second place, the buyer must be in a position to 
deal with any one of several sellers, each acting independ- 
ently of the others, and the seller must be able to offer 
his wares to any one of several independent buyers. The 
laborer must have the option of selling his services to any 
one out of a number of independent employers, and the 



RELATIONS OF THE GOVERNMENT 381 

employer must have the option of selecting from among a 
number of workmen. In other words, competition must 
exist on both sides. Otherwise the seller or the buyer, the 
laborer or the employer, is in danger of being forced to 
accept terms that are manifestly unfair. And this can 
issue only in the discouragement of production, and hence 
in economic decay. 

Of the two conditions stated, the latter — the existence 
of competition — is the more important. If competition 
is active, the seller of wares will point out their good 
qualities, and his competitors will point out their bad ones. 
Even an ignorant buyer is thus in some measure protected 
against injustice. When one party to a contract has no 
competitors to fear, knowledge on the part of the other 
party is of little avail. There is a certain town which I 
can reach only by traveling over a particular railway line. 
The line is in very bad shape ; the ties are rotten and the 
rails are light ; the cars are old and unsanitary. Travel 
on this line involves an unduly large measure of danger 
and discomfort, and I know it. Yet I must buy tickets 
over the line, because I have no alternative. 

11. The government mtist regulate tJie conditions and 
terms of economic contracts when its failure to do so results 
in substantial injustice. 

Now, if there were merely sporadic cases in which con- 
tracts are made under conditions that make possible a 
wide departure from fairness, there would be little need 
for governmental intervention. But when there is an ex- 
tensive field in which such conditions prevail, the need for 
governmental intervention becomes imperative. 

In early times the producer and the consumer were, as 
a rule, neighbors. The tailor and his customer lived in the 
same village. If then the tailor worked under unsanitary 
conditions, the customer had a chance of knowing it. If 
the tailor substituted inferior materials, trusting to the 



382 INTRODUCTION TO ECONOMICS 

customer's ignorance, the deception was likely to make it- 
self known in the wearing of the garments, and react un- 
favorably upon the tailor's business reputation. Fair 
dealing, under the circumstances, was a prerequisite of 
business success, and the man who dealt dishonestly 
sooner or later reaped the due harvest of his misdeeds. 

To-day the man who makes your clothes may live a 
thousand miles away from you. He may be suffering 
from a mild attack of smallpox as he works upon your 
garments. You cannot see the danger that lurks in them. 
The milk that you drink may come from a dairy one hun- 
dred miles away, where no attempt is made to prevent its 
contamination with the germs of disease. The appearance 
of the milk gives you no warning of the fact. Patent 
medicine manufacturers may for years have supplied you 
with remedies containing dangerous amounts of opium ; 
packing houses may have furnished you with meat treated 
with preservatives that undermine your health. Only 
an expert can tell you whether this is true or not ; 
and you can probably ill afford to employ a corps of ex- 
perts to investigate the hidden qualities of the things you 
buy. 

The workman in a large factory is in a similar position 
of helplessness. He cannot estimate the degree of danger 
that unfenced machinery represents. He cannot tell 
whether ventilation is adequate, or whether dust and nox- 
ious gases are properly disposed of. Furthermore, he is 
often unable to judge correctly as to the number of hours 
that he can toil daily without undermining his health. 

Not less significant than the separation of consumer 
from producer has been the development of combinations 
of producers. In many fields, buyers have virtually only 
one seller to deal with. In this state of affairs, there is no 
way in which the consumer can enforce a demand for 
wares of good quality, if wares of poor quality are more 



RELATIONS OF THE GOVERNMENT 383 

profitable. The employee of a monopoly may know that 
unsanitary conditions prevail in its shops, but he may be 
unable to find other employment. Furthermore, the 
prices of monopolized products are likely to be unreason- 
ably high, and this means that the monopolist takes from 
the aggregate income of society a larger share than his 
services warrant. 

12. The government may be called upon to regulate the 
quality of goods or of services. 

Governmental regulation of the quality of commodities 
was exceedingly common in the Middle Ages. The weight 
of the loaf of bread, the width and quality of fabrics, were 
determined by public authority. With the development of 
modern industry much of this regulation fell into disuse. 
Competition was permitted to regulate the quality of com- 
modities as it regulated their prices. The mediaeval kind of 
regulation has, however, survived in a few instances, where 
the retention by a country of a valuable branch of trade for- 
bids individualistic tampering with the traditional standards 
of quality. The Persian government endeavors to suppress 
the use of aniline dyes in the manufacture of rugs, on the 
ground that the employment of these dyes will ultimately 
destroy the foreign demand for Persian rugs. The Japanese 
government inspects all mattings produced for export, and 
regulates their quality. 

The regulation of the quality of goods in most modern 
states has for its chief purpose the preservation of the public 
health. The use of certain ingredients in foods is forbidden; 
the use of other ingredients is limited to certain fixed pro- 
portions. An attempt is made to insure the production of 
many classes of goods under conditions limiting the risk of 
transmission of disease from worker to consumer. No at- 
tempt is ordinarily made to protect the consumer against 
fraud, so long as such fraud does not involve injury to 
health. 



384 INTRODUCTION TO ECONOMICS 

The regulation of quality is carried farther in the case 
of certain goods and services furnished by enterprises en- 
joying a monopolistic position. The quality of gas to be 
furnished to the inhabitants of a city by a private company 
is commonly determined by public authority. The service 
of passenger transportation by street and steam railways is 
often subject to regulation as to quality. In these cases 
regulation is often defended on the ground that the enter- 
prises are of a quasi-public nature. But any enterprise which 
obtains a monopoly of a branch of production is, from an 
economic point of view, in the same position. If a powerful 
monopoly controlled the iron and steel business of the United 
States, there would be no way, except governmental regula- 
tion, of preventing the use of ores rich in phosphorus or 
sulphur in the production of iron destined to be transformed 
into steel rails. This would be a menace to the safety of all 
travelers ; it would therefore be necessary in the end for 
government to regulate the quality of steel produced. 

There is, of course, a danger that the government may 
go so far in the regulation of quality as to check legitimate 
improvements. By the aid of certain chemicals, wheat flour 
of a darker color than consumers like may be bleached to 
a snowy whiteness. The chemicals are admittedly injurious 
to health ; but they are inevitably driven off, either in the 
process of flour manufacture or in the baking of bread, so 
that hardly a trace of them can be found in the latter prod- 
uct. Yet there is some public sentiment in favor of prohibit- 
ing the bleaching of flour. In spite of the danger of over- 
regulation, however, it must be admitted that the principle 
of regulation of quality is salutary, and that the scope of 
regulation is destined to extend itself in future. 

13. A government may regulate the prices of commodities 
or services. 

Governmental regulation of the prices of commodities 
and services was also exceedingly common in the Middle 



RELATIONS OF THE GOVERNMENT 385 

Ages. In modern times such regulation is limited to the 
field of the so-called qitasi-ipublic enterprises. The charges 
of railway companies, of gas and electric light companies, 
of telephone and telegraph companies, and even of such 
petty enterprises as the carriage of passengers in cabs and 
similar conveyances, are commonly regulated by law. 
Such regulation is not actually based upon any economic 
ground, but upon the legal ground that the enterprises 
in question perform functions that the state has often per- 
formed, use the public highways, or employ public powers 
in obtaining rights of way. 

From an economic point of view, all the enterprises 
mentioned except the last ought to be subject to govern- 
mental price regulation, because they are monopolies. 
Without such regulation, a railway company might, if it 
chose, levy such heavy charges upon the carriage of goods 
away from and into a particular locality as to destroy the 
business of that locality and reduce the value of property 
situated there to almost nothing. If the railway is the 
only means of transportation from a mining district, by 
raising rates it can reduce the profits of mine owners to 
nil and force the closing of the mines. It can then buy 
up the mines at a very low figure, and operate them profit- 
ably on its own account. True, this is an extreme case; 
yet it illustrates very well the evils that an unregulated 
monopolistic determination of transportation charges would 
entail. 

If a monopolistic combination succeeded in gaining con- 
trol of the entire iron and steel industry, or of the business 
of mining coal, its powers for extortion would be as great 
as those of the railway in our example. What would one 
give rather than pass a Northern winter without coal ? 
Not all that one has, but a good part of it. If we must 
inevitably see an extension of monopolistic enterprise, as 
many believe, it is inevitable that we shall see an extension 
of the principle of governmental price regulation. 



386 INTRODUCTION TO ECONOMICS 

14. A government may regulate the conditions under 
which labor is performed. 

So long as economic organization remained simple, there 
was comparatively slight need for governmental regula- 
tion of the conditions under which labor was performed. 
A large proportion of those who toiled were their own em- 
ployers, and these could be counted upon to keep their 
work places in tolerably sanitary condition, and to limit 
their hours of labor and the intensity of their exertion to 
the degree that considerations of health demanded. Those 
who worked for wages enjoyed, as a rule, conditions as 
favorable as those of the workmen who were in their 
own employ. The advent of the factory system changed 
conditions materially. Men, women, and children were 
congregated in great masses, under the supervision of 
overseers, many of whom were bent upon getting the maxi- 
mum possible service from the workers under them. Ma- 
chinery took a place in the productive series, and the 
workers were forced to adapt themselves to the speed of 
the machines. Competition between manufacturers led at 
first to a longer and longer working day, and to greater 
and greater intensity of effort. The worker, seeking em- 
ployment, was in no position to stipulate that the working 
day should be limited to a reasonable number of hours, or 
that the labor should not be so intense as to be destructive 
of the health of the laborer. 

Society, it is clear, cannot afford to see the vitality of its 
working classes sapped in an effort to raise to its maxi- 
mum the annual production of wealth. An individual 
employer may profitably pursue the policy of hiring a set 
of workmen, wearing them out in a few years, and replac- 
ing them by another set. From the view point of society 
this policy is as wasteful as it is cruel. The daily exertion 
of each man should be restricted to such measure that he 
may live a life of normal length, enjoying the normal num- 



RELATIONS OF THE GOVERNMENT 387 

ber of years of health and usefulness. Where labor in- 
volves little strain, a man may work ten hours or more a 
day without injury to health. Where the strain is great, 
eight hours may be an unduly long workday. 

When laborers are associated in strong unions, they may 
be able, without governmental aid, to reduce the hours of 
labor to the measure that is desirable from a social point 
of view. Each organization is composed of workers of all 
ages, and there is a natural tendency to maintain a pace 
that is not too rapid for the older workers, hence not so 
rapid as to destroy the physical health of the younger men. 

But strong trade unions control only a small part of 
the economic field. Such associations are especially weak 
in industries employing large numbers of women and chil- 
dren, and these are precisely the classes that are most seri- 
ously injured by long hours of work. Hence it has come 
to be generally recognized that the conditions under which 
women and children work in factories ought not to be left 
to free contract. Hours of labor, for these classes, must be 
regulated by government. 

In almost every modern state some attempt is made to 
regulate by law the hours of labor of children employed out- 
side of the household. Such regulation has been carried 
farthest in the states where the system of large scale produc- 
tion has long been established, as, for example, in England. 
In new industrial states, as in Japan, the regulation of the 
hours of child labor is only in its inception. 

The regulation of hours of labor of women employed 
under similar circumstances is also a well established policy 
in the more advanced states. In the United States a serious 
obstacle to such regulation is found in constitutional provi- 
sions, originally designed to secure the liberty of the indi- 
vidual, but now operating in such a way as to obstruct his 
chances of attaining freedom from industrial slavery. The 
regulation of hours of labor of men has as yet made com- 



388 INTRODUCTION TO ECONOMICS 

paratively slight progress; the policy is, however, destined 
to extend its scope in the future. 

The regulation of other conditions of employment — 
ventilation, sanitation, etc. — has encountered comparatively 
few positive obstacles. The field is, however, so wide, and 
the work of legislatures so slow, that hundreds of thousands 
of workmen are to-day employed under conditions involving 
needless risk of mutilation and death. Still greater is the 
number employed under conditions that predispose the 
worker to disease. Progress in the direction of regulation 
of such conditions is steady, but dishearteningly slow. 

15. The government may regulate rates of wages. 

The regulation of wages is a policy very seldom em- 
ployed in modern times. Doubtless there are many cases 
in which wages are far below the level of productivity of 
labor; and in these cases it is manifest that injustice is done. 
To attempt to fix general wages by law, however, is to en- 
counter grave difficulties. If in any industry wages were 
fixed at a level that seemed to the workers too low, the lat- 
ter would feel justified in refusing to work. If the level of 
wages seemed to employers too high, they would feel justi- 
fied in closing their shops. To force the laborers to abide 
by the rate determined by government would be to inaugu- 
rate an era of universal serfdom. Men would be compelled 
to work on terms fixed by others, and this is the essence of 
serfdom. To force employers to continue production, paying 
wages that seem to them unduly high, would be to confiscate 
property. In either case it is likely that economic progress 
would be checked. 

This does not mean that it would not be possible to se* 
lect certain industries, in which the laborer is most seriously 
exploited, and establish minimum wages there. If the rate 
were too low, some of the laborers could seek other em- 
ployment. If the rate were too high, some of the employ- 
ers could remove their capital to other industries. With 



RELATIONS OF THE GOVERNMENT 389 

the shrinkage in the volume of the industry, the price of 
its products would rise, and this would enable the remaining 
employers to pay the rate of wages fixed. True, some of 
the workers formerly in the industry would be left without 
employment. Some means would have to be found for 
transferring them to other employments. However this 
might be, such regulation, limited to a few fields, would 
encounter no insuperable obstacles, and might result in 
alleviating the distress of some of the most helpless mem- 
bers of society. Some such policy as this has been inaug- 
urated in one of the Australian colonies — with what 
results, we shall better know after the lapse of another 
decade. 

16. Governmental regulation of the relations of capitalists 
and enterprisers is, in some cases, necessary. 

Regulation of the relations between enterpriser and capi- 
talist, or between borrower and lender, tenant and land- 
lord, has largely fallen into disuse. In modern times the 
man who borrows capital is usually possessed of some 
property and of at least an average degree of business ca- 
pacity. It may therefore be taken for granted that he 
will not subscribe to terms that are not to his advantage. 
If a man is willing to borrow capital at ten per cent, 
there is good reason for believing that the annual use of 
the capital is worth to him at least $10 per $100. Accord- 
ingly, there is no reason why the public authority should 
interfere in the transaction. Many of our states do indeed 
have usury laws, limiting the rate of interest that may be 
paid. But these laws are easily evaded, and may be re- 
garded as obsolete. 

Where the enterpriser is a corporate body, as is commonly 
the case in large scale production, the relations between those 
shareholders who are actually in control and those whose 
voice in the management is seldom heard, often require regu- 
lation. The small investor in a large corporation is often 



39° 



INTRODUCTION TO ECONOMICS 



at the mercy of a group of large investors, who manage 
the property in their own interests, not in those of the 
entire body of stockholders. Something akin to the con- 
fiscation of property takes place when the men in control 
of a corporation undertake a " shaking out " of the " little 
men." There is probably no class in the United States 
to-day more in need of governmental regulation than 
these " little men." In the end, doubtless, regulation 
will come, and the small investor in a corporation's stock 
will know whether he is buying property or shadowy hopes, 
and whether or not he will be permitted to keep what he 
has purchased. 

Relations between landlord and tenant assume the guise 
of a social problem wherever the ownership of land has 
become divorced from its cultivation. Where a small 
number of large landholders deal with a vast number of 
small tenants there is often opportunity for the oppression 
of the latter. The tenant who brings a tract of land into 
an excellent state of cultivation should not be evicted by 
the landowner without fair compensation. Justice demands 
that he should be permitted to retain his occupancy of the 
land until he has reaped the fruits of his labor. Upon the 
renewal of his lease he should not be compelled to pay an 
additional sum for the use of the productive powers that he 
has himself created. A wise landlord, it is true, will not deal 
unjustly with tenants who increase the productive power 
of his land ; but not all landlords are wise. The tenant 
may, in some measure, safeguard his interests by the terms 
of the contract under which he enters upon his tenancy ; 
but not all the conditions that may arise during a term 
of tenancy can be covered by a formal contract. Accord- 
ingly, the state, under the conditions assumed, may be 
called upon to regulate the relations of landlord and tenant 
in such a way that the latter may proceed confidently with 
the improvement of the land, knowing that he cannot be de- 



RELATIONS OF THE GOVERNMENT 391 

prived of his due reward. No general problem of this na- 
ture has arisen in the United States. This is due to the fact 
that it is easy for any energetic cultivator to acquire land of 
his own. It is quite conceivable that at some future time, 
when the rising price of land and the resultant concentra- 
tion of holdings have given rise to a permanent class of 
tenant cultivators, the regulation of the relations of land- 
lord and tenant will assume great importance. 

17. Governmental regulation does not change the funda- 
mental cliaracteristics of the existing economic system. 

The foregoing survey is sufficient indication of the 
fact that the regulative activities of government already 
cover a wide field, and we have excellent reason for be- 
lieving that the scope of such activities will in the future 
be greatly extended. In so far, we are drifting away from 
an economic system based upon free private enterprise. It 
cannot be said, however, that the essential nature of the 
existing economic system is thereby altered. That system 
is based upon private initiative ; and though the govern- 
ment may restrict the field in which private initiative finds 
exercise, it does not bind initiative itself. The government 
may prohibit the production of certain articles. In so doing 
it warns private enterprise away from a limited field ; but 
there remain other fields open. The government may fix 
the price at which a certain article may be sold, but this price 
must be left high enough to tempt private enterprise into the 
field ; otherwise the article will not be produced. The 
government may prohibit the employment of certain classes 
of persons, and restrict the hours of labor of other classes. 
Private enterprise is still called upon to furnish employment, 
and the conditions may not be made so onerous as to exclude 
the possibility of liberal profits. A system of regulated 
enterprise is none the less a system of private enterprise. 
A range of choice and an opportunity for gain are left open 
to the enterpriser, and if enterprise is really active, it is 



392 INTRODUCTION TO ECONOMICS 

forever creating new opportunities beyond the reach of 
regulation. 

It may appear that while the existing system of eco- 
nomic organization is in no danger of subversion through 
the extension of governmental regulation, it is in danger of 
being supplanted by a system of governmental enterprise, 
or a socialistic state. We have already many examples 
of direct production of commodities and services by the 
state ; and we may predict an increasing number of such 
enterprises for the future. Must we therefore believe that 
a time will come when the state will enter all branches of 
industry, and organize the whole working population as a 
civil service corps? We shall get some light upon this 
question from a study of the reasons that have led to the 
direct participation of government in industry. From such 
a study we may draw inferences as to whether or not the 
same reasons will lead to an indefinite extension of the 
principle of governmental enterprise. 

18. A government may take over an industry for the pur- 
pose of securing a revenue from the profits of the industry. 

In some instances, the production of a commodity or a 
service is undertaken by government solely with a view to 
securing a revenue. This is the case with the tobacco 
monopoly of France and of some other countries, the salt 
monopoly in British India, and a few other public monop- 
olies. The profits of the business take the place of reve- 
nues that would otherwise be raised by taxation. The 
government of France, instead of operating a tobacco 
monopoly, might levy duties on the manufacture and sale 
of tobacco. If the policy of a government monopoly is 
resorted to, the product is sold to the public at a price 
exceeding cost of production. This excess of price repre- 
sents the net revenue. Let us say that in a given country 
the price will be so high as to yield a net revenue of 
$20,000,000. Now, the government might place a tax 



RELATIONS OF THE GOVERNMENT 393 

yielding $20,000,000 on the private manufacture of the 
article. The manufacturers would add the tax to the price 
paid by the consumers. In either case the government 
would get the same revenue. In either case the consumer 
would bear the burden. Which is the better policy, then, a 
government monopoly or a tax yielding the same revenue ? 

Under private enterprise the price of tobacco will be 
determined by cost of production plus the tax. Say that 
the aggregate cost of production of all the tobacco used 
in the country is $40,000,000. Add to this a tax of 
$20,000,000, and the consumers will have to pay about 
$60,000,000 for it. Under government enterprise, what 
will it cost to produce the tobacco ? The government can 
borrow capital at a lower rate than private enterprisers ; it 
is likely to pay higher wages. Laborers in the employ of 
the government are not likely to work so hard as those in 
the employ of private persons. Let us therefore say 
that the production of tobacco costs the government 
$50,000,000. To this add $20,000,000 profit for the 
public revenues, and the consumers will have to pay 
$70,000,000 for what they would have paid $60,000,000 
under private enterprise, subject to excise taxation. 

From this example the following principles may be 
drawn : When the cost of production in governmental 
shops is greater than the cost in private shops, with a 
given burden upon the consumer a larger revenue can be 
obtained by the government through taxation than through 
governmental enterprise. The cost of production is or- 
dinarily greater in governmental shops than in private 
shops. There is accordingly little reason for an expansion 
of governmental enterprise for the sake of obtaining 
revenue. 

19. The government may assume control of an industry 
for the purpose of regulating the quality or the price of the 
product. 



394 INTRODUCTION TO ECONOMICS 

The assumption by governments of the sole right to coin 
money is an illustration of an industry undertaken by gov- 
ernment for the purpose of regulating the quality of the 
product. Imagine the inconvenience of a currency com- 
posed of coins struck by all the private companies that 
mine gold or silver ! Some would be light weight, some 
heavy ; some would have much alloy, some little. Obvi- 
ously, absolute uniformity and absolute conformity to well- 
known standards are essentials of a currency employed in 
a modern state. And such uniformity and integrity of 
quality can be secured only when the coins are issued by 
an organ of society which regards the interests of society 
as paramount. Doubtless it costs more to coin money in 
government establishments than it would cost in private 
establishments. But this waste is insignificant as com- 
pared with the gains from a currency of unquestioned 
soundness. 

A similar reason has led to the nationalization of the 
railway in many countries, and to a popular demand for 
nationalization in other countries. If we could be sure that 
private railways would furnish good service, at equal terms 
to all, and at reasonable charges, we should never regard 
government ownership of railways as desirable. But of 
this we cannot be sure. We have tried regulation, and are 
still trying it ; and it may be that we shall succeed in our 
endeavors to secure impartial and reasonable treatment of 
shippers and travelers. If we cannot do this, we shall in 
the end make up our minds that the railway is to other 
business enterprises what the coinage is to other com- 
modities — an essential link in almost every business trans- 
action -— and that its social aspects are of paramount 
importance. 

A similar argument applies to the so-called municipal 
monopolies — street railway transportation, the furnishing 
of water and light, and the telephone service. If it is im- 



RELATIONS OF THE GOVERNMENT 395 

possible to regulate the quality and the price of service 
under private management, public management becomes 
necessary. It is, however, to be borne in mind that such 
regulation is impossible only when the people are unable 
to select able and honest officials ; and when such is the 
incapacity of the people, government enterprises stand 
little chance of being managed efficiently and honestly. 

20. Where the utilities created by an industry are not 
appropriable, government operation becomes a necessity. 

In the foregoing instances there is no inherent necessity 
for public operation of industry. In the first case this 
policy is adopted in lieu of a policy of taxation ; in the 
other cases, in lieu of a policy of regulation. We come 
now to consider cases in which government enterprise is 
necessary, because it is the only means of securing certain 
important utilities for society. 

In some branches of industry, practically all the utilities 
created embody themselves in a concrete form, so that the 
producer is able to recoup himself for his costs of production 
through sale of the utilities to those who are to enjoy 
them. The utilities created by a shoe manufacturer are 
embodied in the shoes ; and the manufacturer can obtain 
from the user of shoes a price that will compensate him 
for his expenses. If the consumer will not pay enough 
to cover costs, the shoes ought not to be made, for there 
are no utilities arising from their making that the con- 
sumer cannot appraise. 

We may contrast with the utilities furnished by such 
an industry the utilities furnished by a lighthouse. These 
are scattered far and wide over the waters that are rendered 
safe by the light. They benefit every shipowner whose 
vessel sails in these waters ; every passenger for whom 
the danger of death at sea is thereby reduced ; every 
shipper who pays lower freights because of the smaller 
chance of the foundering of ships. In a year's time the 



396 INTRODUCTION TO ECONOMICS 

utilities contributed by the lighthouse may far exceed its 
cost of maintenance. But if you or I were to erect a 
lighthouse, how would we collect pay for these utilities 
from the beneficiaries ? Clearly, this is no field for private 
enterprise, and yet it is a field in which labor and capital 
may produce greater utilities than elsewhere. The gov- 
ernment, as the representative of society, can alone afford 
to exploit this field. 

Again, an industry may produce some utilities that are 
concrete and appropriable, and some that are elusive, flow- 
ing freely to persons who cannot be made to pay for them. 
In a very slight degree this is true of all industries ; but 
we are concerned only with cases in which this differentia- 
tion of utilities is well marked. We may take as an 
example common school education. The children who 
receive instruction are the immediate beneficiaries ; they, 
or their parents, could be made to pay something for it. 
But all of us who wish a government of officials selected 
by intelligent voters ; all of us who prefer intelligent and 
efficient employees to ignorant ones ; all of us who wish to 
enjoy the products of a rich and varied national produc- 
tion, — are the indirect beneficiaries. A great part of the 
total benefit from educating a child is reaped by persons not 
connected with him by ties of blood or personal interest. 

Now, if the benefit to the child is so great, and so clearly 
appreciated by him or by his guardians, that the entire ex- 
pense of education can be met by tuition, we who are also 
beneficiaries may take our gains gratis. But if this is 
not the case — and, as a rule, it is not — we should be 
very shortsighted if we refused to contribute our share to 
the expenses of his education. From a social point of view 
the benefits of popular education far outweigh the ex- 
penses of it, the expenses cannot in each case be assessed 
upon the beneficiaries; therefore the production of the 
utilities in question must be undertaken by government. 



RELATIONS OF THE GOVERNMENT 397 

Another case may now be cited. Near one of our large 
cities there is an island which is capable of providing 
building lots for a large population. Until recently com- 
paratively few persons could make the island their home, 
on account of the uncertainty and inconvenience of passage 
to the city. A ferry service existed, but the boats were 
small, old, and slow. The owners of the ferry line could 
not furnish better service, however, because the increase in 
fares would not cover the increase in expense. 

The introduction of an efficient ferry service would 
have greatly increased the value of land on the island ; it 
would have furnished an outlet to some of the surplus popu- 
lation of the city, and diminished the evils of overcrowding 
in tenements. These utilities might very well have been of 
sufficient annual value to offset the increased cost of service. 
But the private ferry company could collect no charge for 
such utilities ; therefore it could not make the improvement. 
The city, on the other hand, could very well afford to estab- 
lish a satisfactory service to the island, since the city as a 
whole would get most of these elusive benefits, in addition 
to the fares it would collect from passengers. 

It is obvious that the same principle may be extended to 
a great many enterprises — street railways, steam railways, 
etc. At any given time most of the utilities produced by 
such an enterprise as a street railway system may be of such 
a character that a price can be charged for them. As the 
city grows in size and questions of transportation assume 
greater and greater importance, the utilities that are not 
appropriable increase in number and in value. In the end, 
these utilities may come to be of such significance that the 
transit system ought to be managed chiefly with reference 
to them. In such case public ownership ought to take the 
place of private ownership. 

Now, as population increases, the industries producing 
non-appropriable utilities, along with those that are appro- 



398 INTRODUCTION TO ECONOMICS 

priable, become more numerous — or, more exactly, the 
non-appropriable element in utility production becomes 
more important, relatively to the appropriable element. 
Accordingly, an expansion of public enterprise, in this di- 
rection, seems probable. 

21. When private enterprise is too weak to enter upon a 
productive field, government enterprise is sometimes neces- 
sary. 

One further case in which public enterprise may enter 
the field of production may here be touched upon. Some- 
times private enterprise is not sufficiently daring or skillful 
to enter upon the supplying of utilities even when there is 
no obstacle in the way of charging a price for them. The 
government, if under the control of able administrators, may 
then increase the social welfare by undertaking production 
directly. When a country, long habituated to one mode of 
economic life, is suddenly compelled to adapt itself to new 
conditions, this superiority of public to private enterprise 
may manifest itself. In the last half century many enter- 
prises have been undertaken by the Japanese government, 
in fields ordinarily left to private business. As a class of 
enterprisers developed, the control of such business has 
been gradually transferred to them. When, on the other 
hand, initiative dies out in a people, owing to the weeding 
out of the more intelligent and enterprising elements in 
the population, the government may gradually assume con- 
trol of production and trade. Something of this nature oc- 
curred in the later years of the Roman Empire and in the 
declining period of Venetian history. 

So long as there remains in society a large class of per- 
sons possessing enterprise and ingenuity, there is little 
reason for believing that the extension of the field of public 
enterprise will really narrow the field of private enterprise. 
For the boundaries of the latter can be extended indefinitely 
outward, so long as men have wants that remain unsatisfied. 



RELATIONS OF THE GOVERNMENT 399 

Public enterprise will supplant private enterprise only 
when the latter has become impotent to direct the supply- 
ing of the needs of society. 

22. Summary. 

The basis of the modern industrial system is free private 
enterprise ; such apparent violation of the principle as a 
protective tariff represents does not alter its fundamental 
truth. 

The system of private enterprise has proven highly ef- 
fective in the field of production ; in the field of distribution 
it is impossible to give an unqualified opinion as to the 
justice and expediency of the system. Unregulated private 
enterprise gives rise to serious evils which demand govern- 
mental intervention. 

In general, wherever gross inequality appears in the 
bargaining power of parties to contracts, governmental 
regulation is necessary. The government may be called 
upon to regulate (1) the quality of commodities and services; 
(2) the price of commodities and services ; (3) the condi- 
tions of labor ; (4) the wages of labor ; (5) the relations 
between capitalist and enterpriser. 

Governments often participate directly in industry. 
The purpose of public enterprise may be merely the secur- 
ing of a revenue. This end may usually be better attained 
through taxation of private industry ; hence extension 
of governmental enterprise to this end is improbable. 
The government may take over an industry in order to regu- 
late effectively the quality or the price of the product of 
the industry. Public enterprise having this object is likely 
to become more common with the development of society. 
The government may take over industries, the utility-pro- 
duct of which is not readily appropriable. Public enter- 
prise of this nature is also likely to increase in importance. 
The government may found industries when private enter- 
prise is lacking in efficiency. 



INDEX 



Agriculture, combinations in, 139-40. 
American Federation of Labor, 181 ; 183. 
Apprenticeship, regulations of trade 

unions, 176-78. 
Arbitration, 185-87 ; compulsory, 187-88. 

Bank, ch. XVI ; functions of, 281-87. 
Bank credit, as a substitute for money, 

300. 
Bank deposits, origin of, 291-93. 
Bank loans, character of, 290. 
Bank notes, 297-300. 
Bank reserve, 294-95. 
Bank, savings, 317-19. 
Banking, safety of, 296-97. 
Barter, in international trade, 337-38. 
Bills of exchange, 284 ; 338 et seq. ; effect 

of changes in price of, 344-45 ; 353. 
Bimetallism, 259 ; 262 ; 272-74. 
Bonds, 306. 
Boycott, 182-84. 
Broker, 321-22 ; 310. 
Building and loan association, 319-20. 
Buyers, marginal, 40-41. 
By-products, 129-30. 

Capital, ch. XII ; artificial and natural, 
197-99; as affected by increase in 
labor, 100-01 ; definition of, 193-94 j 
increase of, effect on wages, 204-05 ; 
measured by cost of replacement, 228- 
29 ; natural, as affected by increase of 
artificial capital, 207-08 ; permanence 
of, 194-96; productive and acquisi- 
tive, 196-97; productivity of, 200 et 
seq.; productivity of, as affected by 
risk, 211-13; tendency of, toward 
equalized productivity, 209-11; trans- 
fer of, 280 et seq. ; 303 et seq. 

Capital goods, 192-93; productivity of, 
199 et seq. ; revaluation of, 208. 

Capitalization, 228-31 ; of profits, 248- 
49. 

Charging what the traffic will bear, 74- 
75- 

Checks, 287-88. 



Child labor, 117; 387. 

Classes, economic, 16-18 ; 377-78. 

Clearing house, 293-94. 

Closed shop, 175-76. 

Coinage, 394 ; free, 258-60. 

Collective bargaining, 173-74; 184-85. 

Combinations, ch. IX; 50-51; in agri- 
culture, 139-40; in railway business, 
138 ; partial, 140-41 ; relation to 
concentration, 137; temporary, 139- 
40. 

Competition, 14-16 ; as affecting mo- 
nopoly price, 65-66 ; between laborers 
in different employments, 163-64; 
potential, 66; regional, 87-89; relation 
to enterprise, 237-38; relation to prob- 
lem of justice in distribution, 380-81 ; 
restrictions upon, 16. 

Concentration, ch. VIII ; as affected by 
concentration of wealth, 124-25 ; as 
affected by improvements in trans- 
portation, 123-24 ; as affected by law 
of diminishing returns, 134-35; as 
affected by railway discriminations, 
132; dependent upon corporate form 
of organization, 125-26; in agriculture, 
122-23 I °f wealth, 124-25 ; relation to 
combination, 137; statistics of, 121-22. 

Conciliation, 187. 

Consolidation, 141 ; 144 et seq. ; 149. 

Consumer's goods, 4 ; 192-93. 

Consumption, 8. 

Contract labor, 241-43. 

Coolie labor, 241-43. 

Cooperation, 9. 

Corporation, 125-26; 390. 

Cost of production, ch. V; 238; as de- 
termined by price, 89-90 ; as determin- 
ing price, 48-49 ; 59 ; 89-90 ; marginal, 
relation to value, 55-59; relation to 
international trade, 334-37. 

Cost of replacement, as a measure of 
capital, 228-29. 

Credit, 282-83 ! effect on value of money, 
266-67. 

Credit instruments, 283-84. 



400 



INDEX 



401 



Debt, public, origin of, 304-05. 

Demand, definition of, 39 ; elasticity of, 
in relation to monopoly price, 68-69. 

Demand a supply, 39 et seq. ; in relation 
to price of exchange, 339 et seq. 

Deposits, bank, origin of, 291-93. 

Differentiation, economic, ch. VII ; con- 
ditioned by commercial organization, 
109-10; dependent upon economic 
system, 112-13; dependent upon trans- 
portation facilities, 110-112. 

Diminishing returns, ch. VI ; applicable 
to division of labor, 118-20; applicable 
to principle of concentration, 134-35 '» 
counteracted by improvements, 103-04 ; 
from increased supply of labor, 100-01 ; 
general law of, 101 ; in agriculture, 
95-97 ; in urban improvements, 97-99 ; 
in transportation, 99-100; relation to 
law of wages, 154; to capital, 201-04; 
207. 

Diminishing utility, 24-25. 

Discounts, 289. 

Discriminations, monopolistic, 71-76. 

Distribution^, 

Division of labor, no; advantages of, 
113-16; as stimulating invention, 116; 
disadvantages of, 117-18 ; subject to 
law of diminishing returns, 1 18-19. 

Duties, protective, 353-54 ; revenue, 353. 

Economic classes, 16-18. 

Economic systems, ancient and mediae- 
val, 12-14; modern, 12 et seq. 

Economics, as a developing body of 
thought, 12; definition of, 7; 19-20; 
evolution of, 9-10; object of, 9-1 1. 

Economy in production, 101-13. 

Education, common school, 396-97. 

Enterprise, ch. XIV ; as involving risk, 
236-37 ; definition of, 234-36. 

Enterpriser, 235. 

Entrepreneur, 235. 

Exchange as a cause of economic differ- 
entiation, 107-08; as affecting per- 
sonal values, 32-34. 

Exchange, bills of, 338 et seq. ; effect of 
fluctuating prices of, on exports and 
imports, 344-45 ; 353. 

Exchange economy, 12-14. 

Exchange value, personal, 34-35. 

Exports, diminished by protection, 355- 
56 ; of gold, 346-47 ; taxes on, 350. 



Exports and imports, affected by changes 
in price of exchange, 344-45. 

Finance, 280. 

Foreign exchange, 338 et seq. 
Foreign trade, regulation of, 10. 
Free enterprise, 375 et seq. 
Free silver movement, 272-74. 

Gold, exportation and importation of, 
346-47 ; increase of, effect on prices, 
263-65. 

Gold point, 344. 

Good will, 246-49. 

Goods, 4 ; capital and consumers', 192- 
93 ; definition of, 23-24. 

Government, relation to industry, ch. 
XX. 

Government ownership, 392 et seq. 

Government regulation, conditions re- 
quiring, 381 et seq. 

Gresham's law, 261-62. 

Holding company, 143-44; 3*7 ■ 

Imitation, as affecting personal values, 

30-32. 
Imports, affected by price of exchange, 

344-45 ; of gold, 346-47 ; reaction upon 

exports, 355-56. 
Improvements in production, effect on 

wages, 160-61. 
Infant industries, protection of, 363- 

65- 

Insurance, trade union, 178. 

Insurance company, 320-21. 

Integration of industry, 138-39. 

Interest, ch. XIII; as affected by in- 
crease of capital, 204 et seq. ; decline 
in, effect on wages, 161-62; equiva- 
lent to net rent, 218. 

Interests, conflict of, 50-51. 

International trade, ch. XVIII ; affected 
by improvements in transportation, 
328-29 ; as barter, 337-38 ; relation to 
cost of production, 334-37. 

Inventions, relation to division of labor, 
116. 

Investment company, 316-17. 

Investments, 307 et seq.; demand for 
and supply of, 303-06 ; productivity of, 
308-10 ; security of, 307-08 ; transfer- 
ability of, 308. 



402 



INDEX 



Joint products, 54-55. ' 
Justice in distribution, 378-81. 

Labor, apportionment of, 163-64; con- 
tract, 241-43; definition of, 151-52; 
division of, no; 1 13-16; effect of in- 
crease of, upon productivity, 100-01 ; 
government regulation of conditions 
of, 386-88 ; of children, 387 ; of women, 
387-88 ; price of, 82 et seq. 

Labor, American Federation of, 181 ; 
183. 

Labor organization, ch. XI ; effect upon 
wages, 188-90. 

Laisser-faire, 375-76. 

Land, causes of rise in value, 231 ; price 
of use of, 81-82. 

Large scale production, 126 et seq. 

Legal tender, 260-61. 

Life insurance company, 320-21. 

Loans, bank, 290 ; call, 285 ; disguised 
under form of sale, 282-83 ; producers' 
and consumers', 281-82. 

Marginal productivity, as determining 
wages, 156-57 ; of capital, 201-04. 

Marginal utility, 42. 

Market price, 36 et seq. 

Money, ch. XV ; affected by use of sub- 
stitutes, 266-67; changes in value of, 
271-72 ; definition of, 253 ; functions 
of, 255-56 ; in international trade, 352- 
54; increase of, effects of, 269-71; 
metallic, stability of value of, 277; 
necessary qualities of, 256-58 ; need 
of government regulation of, 257-58 ; 
origin of, 254-55 ; paper, 266 ; 274-77 ! 
private coinage of, 258 ; value of, 262- 
68 ; 300 ; standard, 259-60. 

Monometallism, 259. 

Monopoly, 16; 43; 76; affected by fear 
of competition, 65-66 ; created by law, 
61 ; created by private agreements, 61- 
62 ; definition of, 61 ; discriminations 
in charges, 71-76 ; government regula- 
tion of, 384-86; methods of destroy- 
ing competitors, 64-65 ; municipal, 

395- 

Monopoly price, ch. IV; as affected by 
regard for the future, 69-71; limits 
upon, 75-76 ; theory of, 66 et seq. 

Monopoly profits, 246-52. 

Mortgage, 284 ; 306. 



Natural agents, 197; value of, affected 
by increase of capital, 207-08. 

Natural resources, conservation of, 367- 
68. 

Negotiable paper, 284. 

Notes, bank, 297-300. 

Occupations, differentiation of, 107. 

Opportunity, 233 et seq. ; dependent upon 
economic changes, 236; dependent 
upon lack of competition, 237-38. 

Organization of labor, ch. XI ; relation to 
strikes and boycotts, 183-84. 

Paper money, 266 ; 274-77. 

Parity, maintained by redemption, 260- 
61. 

Patents, 246-49. 

Paternalism, 375. 

Picketing, 182. 

Pool, 141-43. 

Population, density of, as related to 
economic differentiation, 111-12; in- 
crease of, effect on rent, 227-28 ; effect 
on wages, 159-60. 

Price, abnormal, 53-54 ; affected by 
changes in quantity of money, 263-69 ; 
affected by combinations, 50-51 ; 
affected by credit, 266-67 ; affected by 
improvements in transportation, 44-45 ; 
affected by seasons, 52-53; changes 
of, effect on ground rent, 225-27 ; con- 
trolled through consolidation, 149; 
definition of, 35-36 ; effect of rise upon 
wages, 269-70; fluctuations in, 43 et 
seq. ; government regulation of, 385 ; 
importance of, 18-20; influenced by 
ground rent, 86-87; market, %6etseq.; 
monopoly, ch. IV; monopoly, dis- 
criminations in, 73-76 ; monopoly, 
limits upon, 75-76 ; normal, 45 et seq.; 
normal, relation to cost of production, 
48-49 ; 59 ; of finished products, 79-80 ; 
of labor, 82 et seq.; of materials of 
production, 78-79; of use of land, 81- 
82 ; rise of, effect on silver movement, 
274. 

Producer's goods, 4. 

Production, 8-9; cost of, ch. V; cost of, 
as determining normal value, 48-49; 
economy in, 101-03; large scale, 126 
et seq. ; stimulated by freedom of enter- 
prise, 376-77. 



INDEX 



403 



Profit, ch. XIV ; 49 ; 378 ; as a transient 
form of income, 245-46 ; capitalization 
of, 248-49 ; causes of, 238 et seq. ; defi- 
nition of, 238; economic function of, 
249-50; exploitation, 240-43; general, 
244 ; monopoly, 246-52. 

Protection, as creating vested interests, 
366 ; as a means of conserving natural 
resources, 367-68 ; as a means of in- 
suring national independence, 369-71 ; 
as a part of a policy of population, 
368-69 ; effect upon wages, 357-61 ; for 
retaliation, 371-73; of infant industries, 
363-65 ; to non-self-supporting indus- 
tries, 365-66; universal, 356-57. 

Public debts, origin of, 304-05. 

Railways, combinations among, 138 ; dis- 
criminations, 74-75 ; 131-32; national- 
ization of, 394-95. 

Redemption, 260-61. 

Regulation, governmental, conditions 
requiring, 381 et seq. 

Rent, ch. XIII; affected by increase of 
population, 227-28 ; affected by price 
changes, 225-27 ; as affecting price, 
86-87 ; as a residue, 218-21 ; definition 
of, 215-16; gross and net, 217-18; net, 
equivalent to interest, 218; of land, 
dependent on wages and interest, 
222-25 1 relation to cost of capital 
goods, 221-22, 

Reserves, bank, 294-95. 

Retaliation, 371-73. 

Revenue, from government enterprise, 

392-93- 
Revenue duties, 353-54. 
Risk, as affecting productivity, 211 -13; 

309-10; as affecting wages, 165-69; to 

bank deposits, 296-97 ; relation to 

enterprise, 236-37. 

Saving, as origin of capital, 197-99. 

Savings bank, 317-19. 

Sellers, marginal, 40-41. 

Services, as a form of wealth, 4-5. 

Silver movement, 272-74. 

Smith, Adam, 10. 

Socialism, 375 ; 392. 

Specialization, 312-15. 

Standard of living, 2-3 ; effect upon 

wages, 169-71. 
Stock exchange, 312. 



Stocks, 306-07. 

Strike, 181-84. 

Supply, definition of, 39. 

Supply and demand, 39 et seq.; 42; in 

relation to price of exchange, 339 et 

seq. 
Syndicate, underwriting, 315-16. 

Tariff, 350; 375. 

Taxation direct and indirect, 350-52; of 
foreign trade, 349-52. 

Tenancy, government regulation of, 390- 
91. 

Trade, classification of, 326-27 ; condi- 
tions determining, 324-26 ; foreign, 
taxation of, 349-52 ; international, ch. 
XVIII; affected by improvements in 
transportation, 328-29 ; relation to cost 
of production, 334-37; dependent, 
upon relative advantages in produc- 
tion, 327-28 ; interregional, conditions 
determining, 325-26. 

Trade union, 174 et seq.; 387 ; alliances 
of, 178 et seq.; insurance features of, 
178 ; limitations upon membership, 
176-78. 

Transferability, as affecting productive- 
ness of investments, 310. 

Transportation, diminishing returns in, 
99-100; improvements in, effect upon 
prices, 44-45 ; upon economic differ- 
entiation, 110-12; upon concentration, 
123-24; upon international trade, 
328-29. 

Trust, 143. 

Underwriting syndicate, 315-16. 

Unemployment, relation to division of 
labor, 118. 

Unfair list, 183. 

Usefulness, distinguished from utility, 
24-25. 

Utility, 42 ; definition of, 23-25 ; effective, 
27-29; final, 26-27; law of diminish- 
ing, 24-25 ; marginal, 26-27. 

Value, as the common property of 
wealth, 6-7; normal, determined by 
marginal cost, 55-59; personal, 29 
et seq. 

Vested interests, created by protection, 
366. 



4°4 



INDEX 



Wages, ch. X; 82 et seq.; affected by 
collective bargaining, 173-74; by di- 
minishing returns, 154; 161-62; by 
improvements in production, 160- 
61 ; by increase of capital, 204 et seq. ; 
by increase in supply of labor, 159-60 ; 
by increased efficiency of labor, 159; 
by labor organizations, 188-90; by 
protection, 357-61 ; by risk, 165-69 ; by 
standard of living, 169-71; compet- 
itive, 154-55; definition of, 152-53; 
determined by marginal productivity, 



156-59; differences in, 164 et seq.; 
effect of fall in, upon ground rent, 
222-25; government regulation of, 
388-89 ; inequalities in, 379 ; local va- 
riations in, 84-86; relation to foreign 
trade, 336-37. 

Wants, 21-22 ; elasticity of, 22-23 > future, 
' 6; law of, 25. 

Wealth, 1; 4-5; consumption, produc- 
tion and distribution of, 8-9 ; concen- 
tration of, 124-25. 

Women's labor, 387-88. 



